China for the first time joined the ranks of the most-traded international currencies, underscoring the rise of the world's second-largest economy and the growth of the global foreign-exchange market.

The Chinese yuan vaulted to ninth in the Bank for International Settlements' latest report on foreign-exchange turnover, surpassing the Swedish krona and New Zealand dollar, among other widely used currencies.

Trading in the Chinese currency, also known as the renminbi, has more than tripled over the past three years, to $120 billion a day in 2013, the BIS said, referencing survey data from April. Daily U.S. dollar trading in 2013 has averaged $4.65 trillion.

Yuan gains highlight China's ambitions to play a larger role in a market long dominated by the dollar and, to a lesser extent, the euro. Daily global currency flows have risen more than 30% in three years. The yuan ranked 17th in the previous BIS survey, in 2010. The shift also highlights the international nature of the manufacturing supply chain and the flexibility U.S.-based firms can gain by using yuan.

The report also showed the continued dominance of London as a foreign-exchange hub: 41% of daily average currency trading took place in the U.K., up from 32.6% in 1998. The U.S. share of the currency market grew slightly over the same period, rising to 18.9% in 2013 from 18.3% 15 years earlier.

Like the rising yuan, the Mexican peso ranked among the top-10 most-traded currencies. It cracked the list for the first time since 1998, demonstrating the breadth of the ascent of emerging-market currencies. Both the yuan and peso roughly doubled their shares of the market. The Russian ruble, Turkish lira, South African rand and Brazilian real all also accounted for a bigger slice of global flows, while the Korean won and Polish zloty accounted for slightly smaller shares.

In developed-market currencies, flows in the Japanese yen also shot higher in this year's survey, with turnover surging by 63% from 2010. Trading in the dollar against the yen was up by about 70%, the BIS said.

China's central bank on Thursday raised the prospect of a further loosening of controls on cross-border investment, broadening access to the economy and banking sector. Officials have signaled they don't believe efforts to ease restrictions should be slowed by market volatility or other external factors, such as the U.S. Federal Reserve's plans to reduce monetary stimulus. Observers said the shift could hasten more-widespread use of the yuan.

"As China starts loosening up its banking regulations, companies will eventually see the renminbi on par with the euro," said Anil Sawrup, a senior vice president at currency-exchange firm Cambridge Mercantile Group. "Now that it's in the top 10, more businesses will realize the urgency of making payments in the Chinese currency."

Yuan payments by American companies were up almost 90% in the first half of 2013 from the same period a year ago, according to a survey from global payment-services firm Western Union Business Solutions. The survey showed yuan transactions now represent 12% of all U.S. payments to China, up from 8.5% in the first half of last year.

The Chinese government began liberalizing the currency in 2009, but controls still made it difficult for businesses to make payments directly in the yuan. In early 2012, the central bank announced that all Chinese companies could settle their trades in yuan and more directly swap foreign currencies with it.

"Five years ago, it was next to impossible to help our clients pay Chinese suppliers in renminbi because of the government controls," said Guido Schulz, global head of strategic management at AFEX, an international payment service. "Now, it's just another transaction."

Anbo International Ltd., a U.K.-based wood-flooring manufacturer and distributor, has been paying its Chinese suppliers in renminbi for more than two years as a way to cut costs. Since Chinese factories usually raise prices on foreign currency transactions as a cushion for potential exchange-rate fluctuations, paying in the local currency allowed Anbo to get a 3% to 4% discount on the kitchen tops and hardwood flooring it imports from China, said Guren Zhou, managing director at the company.

He estimates Anbo has saved about $1 million since it switched to yuan payments, which also allowed the company to sell their products to home-improvement retailers in the U.K. at a cheaper price than competitors could.

"If you're an importing business, paying renminbi to China will give you flexibility on pricing and allow you to compete with other people who aren't dealing in renminbi," Mr. Zhou said. "It's a really good thing to do."

This rapid growth of foreign exchange and the rise of the yuan underscore why banks and financial centers around the world are keen to grab a slice of offshore yuan trading.

Since China made Hong Kong its first offshore trading center for its currency in 2009, competition has been fierce among global and regional financial hubs to be key yuan markets as Beijing tries to make the currency a serious rival to the dollar's supremacy in global trade. Singapore and London have emerged as the leading candidates, with Tokyo, Sydney, Luxembourg and Kuala Lumpur also vying for a spot.

"The renminbi has been a big growth story over the last year," said Richard Anthony, global head of foreign-exchange electronic trading at HSBC in London. "Trading volumes are increasing not only from corporate clients off the back of global trade, but also from the investor community."

With a stable economy, healthy banking system, and exchange rate "approaching balance," the timing is right for China to push capital-account opening, wrote Sheng Songcheng, head of the central bank's statistics department in an article in the central bank's own Financial News on Thursday. The capital account reflects investment flows, while the current account measures trade flows.

A shift by the Fed to reduce its $85 billion monthly bond-purchase plan, which could trigger fresh swings in global capital flows, shouldn't be allowed to affect China's plans, Mr. Sheng added.

As part of the steps toward a convertible yuan, domestic media have reported that a new free-trade zone to be set up in Shanghai could feature more liberal rules on cross-border yuan flows.

Allowing freer international investment would be a significant change for a nation that has long imposed restrictions on such flows. A tightly controlled exchange rate has also been a key feature of China's reform-era development. The controls have been seen as a way to keep exports competitive and shield the country from waves of currency speculation.

Economists say loosening controls would help stem a slowdown in China's growth by encouraging more efficient use of capital and speeding a transition away from dependence on exports and toward stronger domestic demand.

But the move also brings risk, as a swing to hefty capital outflows could undermine the stability of an overstretched financial sector.

A sharp rise in lending over the past five years has left banks overextended, with the ratio of corporate and household debt to gross domestic product rising to about 170% at the end of 2012, from 117% in 2008.

"In a country where there's significant fragility in the financial system, rapid opening of the capital account could trigger a crisis," wrote Zhang Ming, a senior economist at the government's Chinese Academy of Social Sciences in a recent paper.—Chiara Albanese, Grace Zhu and Amy Li contributedto this article.

Today’s statement and (lack of) policy changes from the Federal Reserve was about as dovish as investors could imagine. The statement from the Fed reads as if Chairman Bernanke handed the pen to Vice-Chair Janet Yellen and let her write it instead, which makes sense if he knows something the rest of us don’t – about her chances for being elevated to the top spot in the near future.

The big issue going into the meeting was whether the Fed would reduce, or “taper,” the pace of net asset purchases from the current rate of $85 billion per month. The consensus was for a reduction of $10-15 billion per month; instead, the Fed didn’t taper at all.

The Fed wrote that the pace of asset purchases was “not on a preset course.” This implicitly rejected Bernanke’s own words at the June press conference that quantitative easing would be finished around the time unemployment hit 7%. When asked about the 7% trigger today, Bernanke treated his old statement like it had the plague, saying there was “no fixed schedule” and “not any magic number” for ending QE, and, that the unemployment rate itself is not a great measure for the state of the labor market.

In other words, don’t expect QE to be over when the jobless rate hits 7%, which the Fed now thinks will happen in March 2014. In terms of when tapering might start, the Fed said it wants to see ongoing improvement in the labor market and an inflation rate moving closer to the Fed’s 2% target.

The Fed meets again in late October but we doubt that will be enough time for the Fed to change its views on tapering. Instead, we think the very earliest the Fed will start tapering is the December meeting, and then only if it sees some clear and unambiguous acceleration in economic growth.

Given our economic forecast, which is that real GDP growth will accelerate to near 3% at an annual rate in Q4 and continue into 2014, we expect the Fed to taper and then wind down quantitative easing by mid-2014.

For today, the Federal Reserve made several other changes to the text of the statement, all of which were more dovish. It noted higher interest rates and said they could slow economic growth and the pace of improvement in the labor market. The Fed also added language that suggests an increase in inflation from current levels would be more consistent with the Fed’s dual mandate. All in all, the Fed set the stage for a much easier monetary policy going forward than it had led the markets to believe over the past three months. So much for transparency.

The one dissent at the meeting was by Kansas City Fed Bank President Esther George, who continued to say policy is overly accommodative.

In addition to releasing its statement, the Fed also provided a new set of economic projections as well as an internal poll on the most likely course for interest rates.

Highlights include the following:

• The Fed cut its forecast for real GDP growth this year to slightly more than 2% (from about 2.5%). It also cut next year by a ¼ point to 3%.• The Fed cut its estimate of the long-term average unemployment rate to 5.5% from 5.6%.• Only three members (out of 17) thought rates should go up in 2014, versus four members in June.• The median federal funds target for the end of 2015 was 0.75% versus 1% back in June.

Based on today’s statement, lack of policy changes, and the sense that Vice Chairman of the Fed, Janet Yellen, seems to have the inside track to getting the nomination, it looks like, the federal funds rate is not going anywhere until 2015. The Fed’s projections say the funds rate will still be about 1.75% in late 2016. And, in his press conference, Bernanke said that it would take two or three more years after 2016 for the funds rate to get back to a more normal 4%.

As we have written many times before, QE3 is not boosting growth, but, instead, is simply adding to the already enormous excess reserves in the banking system. There is little evidence that QE has lifted growth and Price-to-Earnings ratios remain below their levels in early 2008, before QE ever started.

QE is not dealing with the underlying causes of economic weakness at all. The economy has grown slowly, not because of deleveraging, or a recovery from financial problems, but because government is too big. Spending, regulation, and tax rates have all become a bigger burden on the economy – a wet blanket on recovery that the Fed cannot possibly offset.

The good news is that entrepreneurs never give up. New technology continues to left growth. One can only hope that the Fed does not eventually ruin what is left of innovation and creativity by creating too much inflation.

The Federal Reserve has no intention to pull back on its monthly bond buying and instead is more likely to increase it due to economic weakness, investment pro and gold advocate Peter Schiff said.

Fed Chairman Ben Bernanke is trapped in a "monetary roach motel" that will force the central bank to continue quantitative easing, in turn leading to a major economic crisis, Schiff added.

"The recovery that the Federal Reserve is bragging about helping create is 100 percent dependent on the quantitative easing that it is supplying," the CEO of Euro Pacific Capital said Monday during IndexUniverse's Inside Commodities Conference. "Like every drug, the economy's going to need more of it to sustain the phony economy. ... Far from diminishing QE, the next big move is going to expand it."

Play Video

Peter Schiff responds to Twitter critics

As gold has fallen, Peter Schiff has drawn flack on Twitter. But he has a special message for the online ¿naysayers,¿ with CNBC's Jackie DeAngelis and the Futures Now Traders.

(Read more: Did the Fed just pop the stock market bubble?)

On the heels of the financial crisis in 2008, the Fed began the first of what is now three QE programs, with the latest involving purchases of $85 billion a month in Treasurys and mortgage-backed securities.

In recent months, Bernanke and other officials have indicated a desire to start winding down—or "tapering"—the program on belief that the economy is recovering and that prolonged QE carries risks.

However, the Fed stunned the financial markets last week by passing on tapering yet, stressing that the economic data has not improved enough and congressional infighting has stymied fiscal policy.

Schiff, though, said the Fed never intended to taper.

(Read more: BofA got Fed right, here's what they say is next)

"They're going to have to do 100, 115, 125 (billion dollars a month). When the market comes to terms with that it's going to be a whole different ballgame," he said. "Right now, the Fed has to maintain the illusion that there's a method to their madness."

From an investment standpoint, Schiff has had to defend a gold position that has deteriorated as belief has increased that the Fed has managed to stave off inflation.

He attributed the fall of the metal to some of the speculative fervor dying off, as well as a highly publicized bearish call from Goldman Sachs.

Once inflation comes back and the speculators realize they were wrong, Schiff said he the expects the price to roar back up.

Marc Chandler, global head of currency strategy at Brown Brothers Harriman, disputed Schiff's thesis on the Fed's end game, leading to a prolonged and heated debate between the two.

(Read more: Gold is no safe haven: Gartman)

"People like Peter have been arguing that Fed monetary policy has been leading to inflation. But you know what? It hasn't," Chandler said. "Deflation remains a bigger risk to us to date than inflation."

That's not going to be the case for long, said Schiff, who predicted a coming huge drop in the U.S. dollar value and a collapse of the Fed policy structure.

"At some point the dollar is going to fall off the edge of a cliff," he said. "Bond prices are going to go down, and the Fed is going to have no choice but to slam on the brakes, and then we are going to have a worse financial crisis than we had in 2008."

"I'm not trying to say that things are rosy, but I'm compelled to point out thatgovernment borrowing and "spreading around" trillions of dollars is NOT stimulative.When the government borrows, it takes money from someone. When it spends, it givesthat money to someone else. It takes from Peter and gives to Paul. That is onlystimulative if Paul ends up doing something more productive with the money thanPeter would have if he had kept it. I have a hard time believing that is the case.

"It's much more likely that all the borrowing and spending has worked to depress theeconomy, not stimulate it. That's because the bulk of the debt-financed spending hasgone to fund transfer payments. We've borrowed money from the productive members ofsociety and given it to the non-productive sectors (e.g., Solyndra, food stamps,disability payments, etc.).

"So it would be more accurate to rephrase Anatole's statement like this: "without thegovernment borrowing and spreading around hundreds of dollars per living soul permonth, we would be enjoying a stronger, more normal recovery."

I'd like to know why the Fed did the headfake and then kept it in place.

I think the outgoing Fed chair wanted to have an end to the madness scheduled before his departure and the incoming Fed chair did not. A bit of a power struggle and she won. Merely conjecture of course.

2) I could write a book, I suppose, about living in Argentina from 1975-1979, during which time the rate of inflation averaged 7% PER MONTH, and at times reached 25-50% in one month alone.

There is one huge difference between Argentina's and Germany's experience with hyperinflation and the situation in the U.S. today. Argentina and Germany literally "printed money" to pay for the government's spending. Neither country could finance its spending through the sale of debt. Only a fraction of the population used checking accounts; most transactions were cash. The government printed up cash and used that cash to make payrolls and to pay for goods and services. The ever-increasing amounts of cash circulating in the economy quickly became a "hot potato" that was passed around faster and faster. It was the rapidly increasing velocity of money and the rapidly declining demand for that money that turned a lot of money printing into hyperinflation.

Nothing like that could happen today. If the Fed were to print billions and billions of dollar bills to pay for the bonds it is buying, the banking system would just as quickly return the dollars to the Fed in exchange for bank reserves (which pay interest). (In any event the Fed is legally unable to print dollar bills unless it is done in exchange for bank reserves; the Fed can only create bank reserves out of thin air, not currency.) It is thus almost impossible for the Fed to print "too much" money. But the Argentine and German central banks could do that, and they did.

2) I could write a book, I suppose, about living in Argentina from 1975-1979, during which time the rate of inflation averaged 7% PER MONTH, and at times reached 25-50% in one month alone.

There is one huge difference between Argentina's and Germany's experience with hyperinflation and the situation in the U.S. today. Argentina and Germany literally "printed money" to pay for the government's spending. Neither country could finance its spending through the sale of debt. Only a fraction of the population used checking accounts; most transactions were cash. The government printed up cash and used that cash to make payrolls and to pay for goods and services. The ever-increasing amounts of cash circulating in the economy quickly became a "hot potato" that was passed around faster and faster. It was the rapidly increasing velocity of money and the rapidly declining demand for that money that turned a lot of money printing into hyperinflation.

Nothing like that could happen today. If the Fed were to print billions and billions of dollar bills to pay for the bonds it is buying, the banking system would just as quickly return the dollars to the Fed in exchange for bank reserves (which pay interest). (In any event the Fed is legally unable to print dollar bills unless it is done in exchange for bank reserves; the Fed can only create bank reserves out of thin air, not currency.) It is thus almost impossible for the Fed to print "too much" money. But the Argentine and German central banks could do that, and they did.

RICHARD KOO: Forget Hyperinflation — The Fed Is Now Facing The True Cost Of Quantitative Easing

Matthew BoeslerSep. 25, 2013, 8:38 PM

Last Wednesday, the Federal Reserve shocked markets with a surprise decision to refrain from beginning to taper back the pace of its bond-buying program known as quantitative easing.

In the press conference following the decision, Fed chairman Ben Bernanke cited the recent rise in long-term interest rates — spurred by Bernanke's previous press conference in July, during which he seemed to endorse it — as a reason for the delay. Rates had risen too far, too fast, and they were presenting a threat to sustainable economic growth.

Nomura chief economist Richard Koo calls this a "QE 'trap' of [the Fed's] own making," writing in a note to clients that the Fed's decision last week is a clear sign that a "vicious cycle of rising rates and economic weakness has already emerged."

The yield on the 10-year U.S. Treasury note rose as high as 3.0% in the weeks before the Fed announced its decision not to taper.

"Instead of falling back to 2.0% or lower following the Fed’s decision to delay tapering, the 10-year Treasury yield has settled at around 2.5%, which means the next rise in rates could easily take the 10-year yield into 3.0%-plus territory," says Koo. "I worry that this kind of intermittent increase in rates threatens the recoveries in interest- rate-sensitive sectors such as housing and automobiles. That could lead to renewed hesitance at the Fed and prompt it to temporarily shelve or postpone tapering."

That's how the vicious cycle starts.

"While rates might then decline, reassuring the markets for a few months, talk of tapering would probably re-emerge as soon as the data showed some improvements, pushing rates higher and serving as a brake on the recovery," says Koo. "Then the Fed would again be forced to delay or cancel tapering. In my view, recent events have greatly increased the likelihood of this kind of 'on again, off again' scenario, something I warned about in my last report. To be honest, I did not expect it to occur so soon."

Now that it's here, though, Koo writes that the Fed is facing the true cost of QE:

Given that this would never have been a problem if the central bank had not engaged in quantitative easing, I think the US is now facing the real cost of its policy decision.

Had the Fed not implemented QE, long-term rates would not have risen so early in the rebound, and the economic recovery would have proceeded smoothly. Now, any talk of ending QE pushes long-term rates higher and throws cold water on the economy, making it more difficult to discontinue the policy.

That raises the possibility that by buying longer-term securities the central banks of the US, the UK and Japan have placed themselves in a QE “trap” of their own making and will be unable to escape for many years to come. I have previously described QE as a policy that is easy to begin and hard—even scary— to end. The recent drama over tapering signals the start of the less-pleasant second part.

"Amid all the talk of ending QE, I think hyperinflation is a less likely outcome than a QE 'trap'," says Koo. "As soon as the economy picks up a bit, the authorities begin to talk about tapering, which sends long-term rates sharply higher and nips the recovery and inflation in the bud, effectively preventing them from winding down the policy. In this kind of world the economy never fully recovers because businesses and households live in constant fear of a sharp rise in long-term rates."

And isn't what Scott is saying is simply that hyper-inflation is not the concern that most of us here (including me) thought it was? I don't see him saying it was a good idea or that it was costless; merely that it won't be causing hyper-inflation.

I'm not sure. I've read both that deflation and hyperinflation are looming. I know that the American middle class is evaporating like an ice cube on the Vegas strip in July. I don't see a happy ending to the epic debt and the collapse of American exceptionalism.

The Price of PoliticsDebt and deficits impoverish us in ways we can only begin to measure. By Kevin D. Williamson

The headline numbers from the Congressional Budget Office’s newest debt and deficit estimates: Publicly held debt will be at 100 percent of GDP in 25 years, driven by spending on health care and Social Security that will double over the next quarter century. In spite of the fact that taxes as a share of GDP will be higher than their historical average, the debt will continue to grow — and interest payments on that debt will more than double from their current levels.

That’s the best-case scenario.

The more realistic outcome is that each of those measures of debt and spending as a share of GDP will in fact be considerably worse, because our GDP will grow more slowly. We have entered the realm of the vicious circle: Debt and deficits will slow down economic growth, and slower economic growth will make our debt and deficits worse.

Our growing debt slows down economic growth by sucking up capital that could have been used for productive investments. Today’s investors pay higher taxes to fund yesterday’s spending — at the expense of tomorrow’s workers, taxpayers, and entrepreneurs. As the CBO puts it:

The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. . . . Increased borrowing by the federal government would eventually reduce private investment in productive capital, because the portion of total savings used to buy government securities would not be available to finance private investment. The result would be a smaller stock of capital and lower output and income in the long run than would otherwise be the case.

The cost of government spending isn’t just the total in the column marked “total disbursements” on the great Washington cash-flow statement. It is that plus the economic growth forgone as a result of that spending.

The CBO, to its credit, has attempted to get a handle on how heavily that growing debt will weigh upon economic activity in the next 25 years, and the answer is worrisome: Taking into account the economic effect of those deficits, instead of our debt hitting 100 percent of GDP in 25 years, CBO estimates that it will hit something closer to 200 percent of GDP — or 250 percent under the least sunny scenario. (There are even less-sunny scenarios, but the CBO does not believe that it can model them reliably.) Note here that these estimates also assume that the sequester and other deficit-control measures remain in place, which would consequently mean that spending on everything outside of Medicare, Medicaid, Social Security, and debt service — everything else the government does — will be reduced far below current levels, in fact reverting to pre–World War II levels as a share of GDP. That is unlikely to be the case. Assume, then, that those spending and debt numbers look worse to the extent that the ladies and gentlemen in Washington lack the brass to resist demands for more domestic spending — and more military spending, too. The loudest and most insistent critics of the sequester have been defense contractors and the cluster of politicians in Maryland and Northern Virginia most sensitive to their complaints.

This is not just a balance-sheet problem; it is a problem of values and a problem of philosophy. On the one hand, we have the traditional conservative view that the role of government is to protect property and enforce contracts. The traditional antagonist to this view has been socialism, and in a sense it still is, though the old-fashioned Marxist analysis has been supplanted by what we might call the “Hey, the government invented the Internet!” school of economic analysis.

The Left has of late been atwitter about a new and energetic expression of that banal idea in a book called “The Entrepreneurial State,” written by Professor Mariana Mazzucato, a scholar in the field of technology policy at the University of Sussex. Professor Mazzucato’s argument is not really a matter of technology policy at all but a moral argument, and a poor one. Because government has made economic interventions in various ways in the past (e.g., through military research that has supported advances in things like smart phones and pharmaceuticals), it is immoral for businesses to look to minimize their tax payments or otherwise resist political control of their capital, and it is immoral — not merely mistaken, but immoral — to look to entrepreneurs, venture capitalists, and the like as the main drivers of economic innovation. Professor Mazzacuto writes:

In this era of obsession with reducing public debt — and the size of the state more generally — it is vital to dispel the myth that the public sector will be less innovative than the private sector. Otherwise, the state’s ability to continue to play its enterprising role will be weakened. Stories about how progress is led by entrepreneurs and venture capitalists have aided lobbyists for the U.S. venture capital industry in negotiating lower capital gains and corporate income taxes — hurting the ability of the state to refill its innovation fund.

In support of her claim that the state is an effective entrepreneur, Professor Mazzucato cites the government’s role in developing what we now know as the Internet, its $500,000 investment in Apple through a small-business program, the CIA’s financial sponsorship of GPS technology, etc. This is a classic example of single-entry bookkeeping: Every government intervention that has some connection, however tenuous, with a profitable product in current use is listed on the credit side of the entrepreneur-state’s ledger. Nothing is listed on the debit side. How many Solyndras do we have for every $500,000 handout to Apple? How many Fannie Maes and housing bubbles for every GPS or nascent Internet? Do not look for Professor Mazzucato and those of her kidney to answer that question, or even to acknowledge it in any serious way. But past successes in state entrepreneurship can justify future adventures only to the extent that past efforts have been on balance successful. That is a difficult case to make.

And the debit side has to include much more than such obvious disasters as Solyndra. The government does support pharmaceutical and medical research in many ways — but how many potentially useful pharmaceuticals and medical products have been kept off the market by the federal regulatory apparatus and the enormous costs it imposes on effective and defective products alike? (And how much damage has been done by the FDA’s incompetent policing of defective products that do reach the market?) How many businesses have not been started, and how much innovation forgone, because of the state’s rapacious appetite for capital? For a sense of scale, consider that, as of October 2011, the world’s largest hedge-fund company was Bridgewater Associates of Westport, Conn., with $77.6 billion under management. That total is well less than Medicare loses to fraud year in and year out. You’d have to combine the assets of the three largest private-equity firms to match what Medicare loses to fraud in a typical year, whereas the holdings of venture-capital titans such as Andreessen Horowitz are hardly even rounding errors on that amount.

Would you invest with a firm with that record?

Government is what government does, and what government does is what government spends. Our government is a corrupt HMO with an underfunded pension plan attached, and a few aircraft carriers in tow. Contra Professor Mazzucato, the confiscatory taxes the federal government wishes to impose upon Apple et al. are not being used to replenish any such “innovation fund” as may exist in her imagination, but to prop up the corrupt, wasteful, and destructive programs that make up the great majority of its spending. Federal support for basic science research is pretty low on the list of things that small-government conservatives are worried about, and George Will is not entirely misguided in his admiration for the National Institutes of Health. But the neo-Nehruvian dream of the state as main entrepreneur cannot intellectually survive even the most modest attempt to balance benefits against costs.

As the CBO sees it, the economic weight of the deficits we’re expected to add just in the next 25 years is enough to bring the national debt from 100 percent of GDP to 200 or 250 percent of GDP, i.e., from paralyzing to catastrophic. The deficits we’ve run for the last 25 years have imposed costs of their own. That the costs mainly manifest themselves negatively — in the form of businesses that don’t exist, profits that aren’t collected, and help that is not wanted — does not make them any less real, or less tragic. In the long run, the deficit is as much about whether you have a decent job or die from diabetes complications as it is about figures in CBO estimates. The price may not always be obvious, but you pay it every day.

In his parting act, Federal Reserve Chairman Ben Bernanke has decided to continue printing some $85 billion per month (6 percent of GDP per year) and spend those dollars on government bonds and, in the process, keep interest rates low, stimulate investment, and reduce unemployment.

Bernanke’s dangerous policy hasn’t worked and should be ended. Since 2007 the Fed has increased the economy’s basic supply of money (the monetary base) by a factor of four! That’s enough to sustain, over a relatively short period of time, a four-fold increase in prices. Having prices rise that much over even three years would spell hyperinflation.

And while Bernanke says this is all to keep down interest rates, there is a darker subtext here. When the Treasury prints bonds and sells them to the public for cash and the Fed prints cash and uses it to buy the newly printed bonds back from the public, the Treasury ends up with the extra cash, the public ends up with the same cash it had initially, and the Fed ends up with the new bonds.

Yes, the Treasury pays interest and principal to the Fed on the bonds, but the Fed hands that interest and principal back to the Treasury as profits earned by a government corporation, namely the Fed. So, the outcome of this shell game is no different from having the Treasury simply print money and spend it as it likes.

The fact that the Fed and Treasury dance this financial pas de deux shows how much they want to keep the public in the dark about what they are doing. And what they are doing, these days, is printing, out of thin air, 29 cents of every $1 being spent by the federal government.

I have heard one financial guru after another discuss Quantitative Easing and its impact on interest rates and the stock market, but I’ve heard no one make clear that close to 30 percent of federal spending is now being financed via the printing press.

That’s an unsustainable practice. It will come to an end once Wall Street starts to understand exactly how much money is being printed and that it’s not being printed simply to stimulate the economy, but rather to pay for the spending of a government that is completely broke — with long-term expenditures obligations that exceed its long-term tax revenues by $205 trillion!

When Wall Street wises up to our true fiscal condition (and, some, like Bill Gross already have), it will dump long-term bonds like hot potatoes. This will lead interest rates to jump and make people and banks very reluctant to hold money earning no return. In trying to swap their money for goods and services, the public will drive up prices.

As prices start to rise and fingers start pointing at the Fed for fueling the inflation, QE will be brought to an abrupt halt. At that point, Congress will have to come up with an extra 6 percent of GDP on a permanent basis either via huge tax hikes or huge spending cuts. Another option is simply to borrow the 6 percent. But this would raise the deficit, defined as the increase in Treasury bonds held by the public, from 4 to 10 percent of annual GDP if we take 2013 as the example. A 10 percent of GDP deficit would raise even more eyebrows on Wall Street and put further upward pressure on interest rates.

But why haven’t prices started rising already if there is so much money floating around? This year’s inflation rate is running at just 1.5 percent. There are three answers.

First, three quarters of the newly created money hasn’t made its way into the blood stream of the economy – into M1 – the money supply held by the public. Instead, the Fed is paying the banks interest not to lend out the money, but to hold it within the Fed in what are called excess reserves.

Since 2007, the Monetary Base – the amount of money the Fed’s printed – has risen by $2.7 trillion and excess reserves have risen by $2.1 trillion. Normally excess reserves would be close to zero. Hence, the banks are sitting on $2.1 trillion they can lend to the private sector at a moment’s notice. I.e., we’re looking at an gi-normous reservoir filling up with trillions of dollars whose dam can break at any time. Once interest rates rise, these excess reserves will be lent out.

The fed says they can keep the excess reserves from getting lose by paying higher interest on reserves. But this entails poring yet more money into the reservoir. And if interest rates go sufficiently high, the Fed will call this practice quits.

As excess reserves are released to the economic wild, we’ll see M1, which was $1.4 trillion in 2007 rise from its current value of $2.6 trillion to $5.7 trillion. Since prices, other things equal, are supposed to be proportional to M1, having M1 rise by 219 percent means that prices will rise by 219 percent.

But, and this is point two, other things aren’t equal. As interest rates and prices take off, money will become a hot potato. I.e., its velocity will rise. Having money move more rapidly through the economy – having faster money – is like having more money. Today, money has the slows; its velocity – the ratio GDP to M1 — is 6.6. Everybody’s happy to hold it because they aren’t losing much or any interest. But back in 2007, M1 was a warm potato with a velocity of 10.4.

If banks fully lend out their reserves and the velocity of money returns to 10.4, we’ll have enough M1, measured in effective units (adjusted for speed of circulation), to support a nominal GDP that’s 3.5 times larger than is now the case. I.e., we’ll have the wherewithal for almost a quadrupling of prices. But were prices to start moving rapidly higher, M1 would switch from being a warm to a hot potato. I.e., velocity would rise above 10.4, leading to yet faster money and higher inflation.

I hope you’re getting the point. Having addicted Congress and the Administration to the printing press, there is no easy exit strategy. Continuing on the current QE path spells even great risk of hyperinflation. But calling it quits requires much higher taxes, much lower spending, or much more net borrowing (with requisite future repayment) from the public. Yet weaning Uncle Sam from the printing press now is critical before his real need for a fix – paying for the Baby Boomers’ retirement benefits – kicks in.

The one caveat to this doom and gloom scenario is point three – increased domestic and global demand for dollars. The Great Recession put the fear of God into savers worldwide. And the fact that U.S. price level has risen since 2007 by only 15 percent whereas M1 has risen by 88 percent reflects a massive expansion of domestic and foreign demand for “safe” dollars. This is evidenced by the velocity of money falling from 10.4 to 6.6. People are now much more eager to hold and hold onto dollars than they were six years ago.

If this increased demand for dollars persists, let alone grows, inflation may remain low for quite a while. But our ability to get Americans and foreigners to hand over real goods and services in exchange for very few green pieces of paper is hardly guaranteed once everyone starts to understand the incredible rate at which Uncle Sam is printing and spending this paper. Once everyone gets it into their heads that prices are taking off, individual beliefs will become collective reality. This brings me to my bottom line: The more money the Fed prints, the more it risks everyone starting to expect and, consequently produce, hyperinflation.

Laurence Kotlikoff is Professor of Economics at Boston University and co-author of The Clash of Generation and author of Jimmy Stewart Is Dead.

If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time. Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that.

Investment Outlook October 2013Survival of the Fittest?William H. GrossArticle IntroductionArticle Main Body

I hate crows and my wife Sue hates bugs, but like most married couples we have learned to live with our differences. Crows eat bugs though, and bugs eat bugs, and that scientific observation sets the context for the next few paragraphs of this month’s Investment Outlook.

About those crows: They screech, they jabber, they complain from the treetops and then once on the ground they hop, hop, hop all over the street looking for garbage. Flying seems beyond them – too much effort to flap those ebony wings. They prefer to play chicken with my car rolling into the driveway at 5 mph. “Get out of my way,” they seem to be saying. “We’re probably on the endangered species list and if you hit us, you’re the one that’ll be sorry.” Probably true – damn crows. About those bugs: Sue hates any kind of bug, but especially those with lots of legs. Creepy crawly legs. Centipedes, Millipedes, even Octapedes and there are no eight-legged bugs. And of course there’s the world’s perennial favorite – the cockroach. Who could love “La Cucaracha?” Not Sue, that’s for sure.

Our hatred of bugs and crows though is perhaps too strong of a word. “Dislike” or “not like” might be better. Nature itself is rather neutral when it comes to any living thing – including us humans – so perhaps we Grosses should take a lesson from the grand Mother. And to think of it, perhaps it is nature and its rather incomprehensible neutrality that “bugs” me the most – not crows. Why, I wonder, is it that nature seems so indifferent to life, that it promotes, even encourages the Grim Reaper as a necessary condition for living and evolving? Why must it create multiple examples of a living species and then rather innocently step aside as they voraciously consume one another? Must Darwin and his survival of the fittest be God’s philosophical guidepost? Why couldn’t a loving and theoretically omniscient creator just make it simple as opposed to infinitely complex? Why couldn’t the Mother, for instance, pattern an outcome that produced a pride of one or two perfectly healthy lion cubs as opposed to three or four with flaws – the latter two becoming hyena food because they were too slow or insufficiently hyena-aware. So the hyenas could live, you say? Then why create hyenas in the first place – leave them out of the plan and prevent the needless suffering. Of course we would then probably all become grazing cows, chewing our cuds in a more pastoral but less painful setting. Perhaps – but better a cow, I think, than millions of crows eating billions of bugs. Hindus would agree. If I were the creator I’d do it better, but then I’m not. As for this life – count me in by necessity. I’ll play the game but reluctantly. My rage and incomprehension at the pain and death of living things – especially two-legged ones – is as old as Mother time herself, but forever fresh and completely unanswerable.

Speaking of questions with no answers: 1) investors wonder what happened to the taper, 2) why the Fed seemed to change its mind and 3) where of course do we go from here? A few days before the September meeting, I tweeted that the Fed would “tinker rather than taper,” which was close to the end result, but still not totally accurate. They refused to budge, with an uncertain economy being the explanation. Ben Bernanke sort of sat back and did nothing, just like Mother Nature with her crows and bugs. The debate though is actually only so much noise in the scheme of things. The Fed will have to taper, cease and then desist someday. They can’t just keep adding one trillion dollars to their balance sheet every year without something negative happening – either accelerating inflation, a tanking dollar or a continued unwillingness on the part of corporations to invest because of the resultant low and unacceptable returns on investment. QE (quantitative easing) has to die sometime. Just like Mother Nature, death and creative destruction seem to be part of the Grand Economic Scheme.

What matters most for bond and other investors though is not timing of the taper nor the endpoint of QE, but the policy rate: 1) how long it stays where it is, 2) what is the long-term neutral rate in a highly levered economy and 3) can a chastened central bank convince investors that it knows the answer and can be trusted to stick to it? It’s the policy rate, both spot and forward, that prices markets and drives economies and investment decisions. QEs were simply a necessary medicine for rather uncertain and illiquid times. Now that more certainty and more liquidity have been restored, it’s time for the policy rate and forward guidance to assume control. Janet Yellen, future Fed Chairperson, would agree, as would oft-quoted Michael Woodford, Columbia University professor and 2012 Jackson Hole speaker, who seems to have become the private sector’s philosophical guru for guidance and benchmarks, that will now attempt to convince an investment public that what you hear is what you get.

But if QE is soon to be out, and guidance soon to be what remains, I think investors should listen and invest accordingly. Not with total innocence, but sort of like a totally hyena-aware lion cub – knowing there’s bad things that can happen out there in the jungle, but for now enjoying the all clear silence of the African plain. In bond parlance, the all clear sign would mean that the Fed believes what it says, and if their guideposts have any credibility, they won’t be raising policy rates until 2016 or even beyond. The critical question to ask in terms of the level and eventual upward guide path of the policy rate is how high a rate can a levered economy stand? How much wood can a woodchuck chuck? How high a rate can a homebuyer handle? No one really knows, but we’re beginning to find out. The increase of over 125 basis points in a 30-year mortgage over the past 6–12 months seems to have stopped housing starts and importantly mortgage refinancings in its tracks. It was the primary “financial condition” that Chairman Bernanke cited in his September press conference that shifted the “taper to a tinker to a chance” that maybe they might do something next time.

The 30-year mortgage rate of course is connected to the policy rate and its pricing in forward space. All yields in composite are what an economy has to hurdle in order to grow at historically hoped-for rates at 2–3% real and 4–5% nominal: Treasury yields, mortgage yields, corporate yields and credit card yields, all in composite. Ray Dalio and company at Bridgewater have the concept down pat. The objective, Dalio writes, is to achieve a “beautiful deleveraging,” which assumes minimal defaults and an eventual return of investors’ willingness to take risk again. The beautiful deleveraging of course takes place at the expense of private market savers via financially repressed interest rates, but what the heck. Beauty is in the eye of the beholder and if the Fed’s (and Dalio’s) objective is to grow normally again, then there is likely no more beautiful or deleveraging solution than one that is accomplished via abnormally low interest rates for a long, long time. It is PIMCO’s belief that Yellen, Woodford and Dalio are right. If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time. Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that. The reason to place your bet on the “don’t come” 2016 line is what we have just experienced over the past few months. We have seen a 3% Treasury yield and a 4½% 30-year mortgage rate and the economy peeked its head out its hole like a groundhog on its special day and decided to go back inside for another metaphorical six weeks. No spring or summer in sight at those yields. The U.S. (and global economy) may have to get used to financially repressive – and therefore low policy rates – for decades to come. As the accompanying chart shows, the last time the U.S. economy was this highly levered (early 1940s) it took over 25 years of 10-year Treasury rates averaging 3% less than nominal GDP to accomplish a “beautiful deleveraging.” That would place the 10-year Treasury at close to 1% and the policy rate at 25 basis points until sometime around 2035! I’m not gonna stick my neck out for that – April, May and June of 2013 have taught me a lesson that low yields can become high yields almost overnight. But they should stay abnormally low. A highly levered U.S. and global economy cannot deleverage “beautifully” without repressive future policy rates, which in turn help to contain 5s and 10s although with much less confidence and more volatility as investors have seen recently.

Investment Implications

In betting on a lower policy rate than now priced into markets, a bond investor should expect a certain pastoral quietude in future years, much like that grazing cow, I suppose. Not that exciting, but what the hay, it’s an existence! Portfolios should emphasize front end maturity positions that are stabilized by the Fed’s forward guidance as well as volatility sales explicitly priced in 30-year agency mortgages. Because of the inflationary intention of low policy rates, TIPS (Treasury Inflation-Protected Securities) and the avoidance of anything compositely longer than say 7–10 years of maturity should be favored (long liability structures such as pension funds excepted). PIMCO believes that such a modeled portfolio could likely return 4% in future years.

A bond investor’s focus must simplistically be this: In this new age where short-term yields cannot go lower, let the yield curve, volatility and acceptably priced credit spreads be your North Star. Duration and its empowering carry are fading from the nighttime sky, especially for 10- and 30-year maturities. Mother Nature nor Mother Market cares not a whit for your losses nor your hoped for double-digit return from an equity/bond portfolio that is priced for much less. Be a contented cow, not a voracious crow, and graze wisely with increasing certainty that the Fed and its forward guidance is your best bet for survival.

"Survival Speed Read"

1) Focus on front-end yields, because the Fed can’t raise policy rates in a levered economy. 2) Respect all living things, even crows and bugs.

Why Uncle Sam is hoarding goldThe Treasury says it won’t tap its gold stockpile, even to avoid a default

By Brett Arends CORRECTION: An earlier version of this story misidentified a holding owned by the Appleseed fund.

Grab any Wall Street trader in a bar, or any portfolio manager in his office, and he’s likely to tell you gold is finished.

It’s silly, nothing more than a shiny metal, a substance with little use and little real value, a “barbarous relic,” and the stuff of nothing more than superstition. Only a fool would own any gold in his portfolio.

Right?

After all, its value has plunged by $500 an ounce in the past year, and $100 just in the past month. Gold hasn’t even rallied during the budget crisis: So much for its “safe haven” status.

There is just one nagging problem with this story line. One group of people disagrees. And I am not talking about wacko gold bugs in Arizona (“the ex-husband state”) with tinfoil on their heads.

AFP/Getty Images

Enlarge Image I am talking about the people running the United States Treasury.

They remain firm believers in gold. Big-time.

This week I asked them if they would consider selling some of the country’s gold reserves to pay the bills if the budget crisis escalates later this month.

Their response? Not a chance.

The Treasury has considered that option, among the many others, and rejected it. “Selling gold would undercut confidence in the U.S. both here and abroad,” a spokeswoman said, “and would be destabilizing to the world financial system.” She was quoting an official position laid out last year in a letter to Senator Orrin Hatch, but so far apparently little noticed on Wall Street.

The Treasury’s position is, in a word, extraordinary. We hear all this skepticism these days about gold. Yet the Treasury itself considers U.S. gold holdings to be a key element in maintaining confidence in the country’s soundness—and the stability of the international financial system.

I thought gold was a joke. Totally over. I thought no one cared about gold. But if that were really the case, why wouldn’t the government just dump the holdings for whatever it could get?

To get the full measure of that statement, it is worth reminding ourselves of where we are now. The government has already shut down and there is a non-trivial risk that in just over two weeks it may actually default on its debts. I’m not saying it’s likely, but I am saying the risk is real. To prevent that happening, Congress, which can’t even agree to keep open the Bunker Hill Monument for tourists, must agree to hike the debt ceiling. If it doesn’t, the federal government will quickly run out of money.

The Treasury has considered various scenarios and contingencies, officials say. They have concluded that delaying government payments across the board—from Social Security to debt interest — would be the least harmful approach.

Click to Play What do gold prices do during a shutdown?On the second day of the shutdown, the markets were relatively stable -- but what about gold? Heard on the Street editor Liam Denning joined MoneyBeat to discuss. Photo: AP.

In other words, according to the official position of the U.S. Treasury, the promises and commitments of the government, and its “full faith and credit,” are actually worth less than gold. They’d rather default than lose their bullion.

The federal government has about 8,100 metric tonnes of gold, held in places like Fort Knox. At current prices that’s worth about $340 billion. That would only keep the government going for about a month, which tells you how little gold we really have in relation to our commitments.

Governments in Europe, including those in Great Britain and Switzerland, have sold off some of their gold in the past (much of it near the bottom of the market 13 years ago).

Josh Strauss, co-manager of the Appleseed mutual fund (and a gold fan), calls the Treasury’s admission extraordinary. “With gold on the ropes this year, investors are increasingly questioning the intrinsic value of gold,” he says. “Given the craziness in D.C., it seems to me that investors should really be questioning the intrinsic value of paper dollars backed by feckless promises.”

Strauss’s fund has a big position in gold. He owns, and especially likes, the Central GoldTrust /quotes/zigman/27810/quotes/nls/gtu GTU +1.12% , a closed-end fund with gold in its vaults. The shares trade for 6% less than their net asset value, and because it is a stock your capital gains, if any, will be taxed at the lower rates levied on shares, rather than at the higher rates levied on collectibles such as gold.

I confess I am a gold agnostic—neither a confirmed skeptic, nor a true believer. I try to keep an open mind. (I do see some value in owning it, since in the past it has often tended to do well when other assets, such as stocks and bonds, have done badly.) But the Treasury’s comment is really remarkable. The Treasury suspects that if the government just sold its gold, all those “gold skeptics” who run the financial markets would panic.

The Yellen DifferenceThe Tobin Keynesians are back in charge at the Federal Reserve.

Markets are (mostly) cheering President Obama's appointment of Janet Yellen to the second most powerful job in the world for its continuity: The current Federal Reserve vice chairman was present at the creation of Chairman Ben Bernanke's extraordinary monetary exertions, and the market belief is that she will keep it all going. This may be true, yet it obscures an important distinction between the two that may have consequences down the road.Related Video

Assistant editorial page editor James Freeman on why President Obama picked Janet Yellen to succeed Ben Bernanke, and what the choice means for monetary policy and markets. Photos: AP

Mr. Bernanke is more of an improvisational policy maker who came to his post-crisis actions by what he considers to be the necessities of the moment. His academic roots are as a monetarist, and he justifies his policy mainly in those terms. He considers his various quantitative easings to be entirely consistent with Milton Friedman's monetary history of the Great Depression, however much other monetarists might disagree.

Ms. Yellen is a distinguished academic economist but she is also an unreconstructed Keynesian. She studied under James Tobin, the late Yale economist whose ideas dominated American economic policy from the 1950s through the 1970s. Friedman monetarism was in part a revolt against the Tobin school, which to oversimplify made unemployment a central focus of monetary policy. In the Tobin-Yellen view, the first task of a central banker is to promote full employment rather than to maintain price stability.

This is the intellectual underpinning to keep in mind when you read that Ms. Yellen favors "easy money" or is a monetary "dove." And it has consequences that are likely to appear over time if she is confirmed by the Senate as expected.

One is that she believes wholeheartedly in the wisdom of government to steer the private economy and business cycle. When she testifies before Congress as chairman, you can expect her to support spending "stimulus" for growth in the short-term but tax increases to reduce deficits in the longer term. President Obama will not be disappointed.

Her ascension also means the revival of the Phillips Curve, and its academic cousin, NAIRU, or the non-accelerating inflation rate of unemployment. These nostrums hold that there is a trade-off between inflation and unemployment: that you can have rapid growth or low inflation, but you can't have both at once for any length of time. Thus the Fed must constantly be fine-tuning Fed policy to manipulate the business cycle.

This view dominated Fed councils for decades until the Paul Volcker-Alan Greenspan era, when it was marginalized because it seemed to lose any predictive power. In both the 1980s and 1990s, the U.S. had rapid growth and low inflation as the Fed kept its focus primarily on price stability. But the Tobinites never went away, and in Ms. Yellen they have one of their own back in charge.

At the current economic moment, all of this is likely to lead Ms. Yellen to continue to use Fed policy to try to push the jobless rate much lower, and perhaps for a longer period of time. In a February 11 speech this year to the AFL-CIO, she said that "attaining maximum employment" must take "center stage" for a long time to come.

And in 1995 she said during a debate on inflation targeting that "when the goals conflict and it comes to calling for tough trade-offs, to me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target." This helps to explain why, even in the Bernanke era, Ms. Yellen has often pushed behind the scenes for even more aggressive bond purchases.

Ms. Yellen's defenders says she really isn't a dove and they point to her 2006 warning about a housing bubble and its risks for the larger economy. Full marks for that. But the problem is that by 2006 the mortgage-securities and housing bubbles were so large and distended that substantial economic harm was inevitable. The time for the Fed to have begun tightening was in 2003 and 2004 when it was keeping interest rates at 1%-2% even as the economy was growing by nearly 4% a year and commodity prices were exploding. Ms. Yellen was no great public dissenter from that historic Greenspan-Bernanke mistake.

All of this monetary musing may seem beside the point with little inflation and a jobless rate still at 7.3%. But everyone loves a central banker when she's easing. The test of a Fed chairman is whether she has the fortitude to tighten money when it is required but when the politicians and Wall Street are saying it's still premature. That was a test that Fed chairmen, operating on Keynesian principles, failed repeatedly in the late 1960s and 1970s.

As for Mr. Bernanke, he must feel at least some frustration that someone else will be responsible for completing his post-panic monetary experiment. Having failed to start tapering bond purchases in September, his window for doing so may be shut as power and deference begin to flow to his successor.

Our view of the Bernanke era is that he contributed greatly to creating the bubble and panic, then acted admirably and creatively to stem the crisis. (MARC: Disagree!) His policy since the recovery has failed to live up to its growth expectations, and now the verdict of history will depend on a monetary exit that Ms. Yellen will steer.

A serious alternative to the dollar is still a long way off, but the latest shenanigans on Capitol Hill have given the search for them renewed momentum

Such is the dollar's dominance that, to begin with at least, investors might simply have to take default on the chin. Photo: Bloomberg News

By Jeremy Warner, Assistant Editor

8:18PM BST 14 Oct 2013

All great empires – from the Greek, to the Roman, the Spanish and the British - have at their heart a dominant means of exchange which is very much part of their political and social hegemony. Once upon a time, it was Roman coinage which was the world's pre-eminent currency. In more recent times it was the British pound. Today, it's the US dollar to which international investors flock as a safe haven for their money. Highly liquid and apparently reliable – until recently at least – nothing else comes even remotely close to the greenback's dominant position in the international monetary system.

That this position – what Giscard d'Estaing referred to as America's "exorbitant privilege" – could so casually be put at risk by politicians on Capitol Hill is an extraordinary spectacle that may be indicative of a great power already seriously on the wane.

With the pound, the fall from grace was swift. Britain emerged from the devastation of the First World War an irreparably damaged economic and military power, with crushing debts and a deeply impaired manufacturing sector.

The dollar was able quickly to usurp the pound's position. Final defeat for sterling came with Britain's decision to leave the gold standard in 1931 – an economically sensible decision but a psychological turning point for sterling from which it never recovered.

Lack of any credible alternative means it won't happen so quickly with the dollar. For all the progress of the last 30 years, China for now remains a much smaller economy than the US and in any case is nowhere near ready financially to assume such a role. As for the euro, the dollar needn't trouble itself much about this one-time pretender to the throne.

Yet rarely before has international dissatisfaction with the dollar's role as reserve currency to the world been as great as it is now. The most visible anger comes from China, with more than $3 trillion of dollar foreign exchange reserves, $1.3 trillion of them held in US Treasuries. For ordinary Chinese, it has come as a revelation to discover they own so much American debt. That they own it in a country which because of political brinkmanship may actually default has provoked understandable fury.

"It is perhaps a good time for the befuddled world to start considering building a de-Americanised world", China's official government news agency has said.

A steady erosion of trust which began with the financial crisis five years ago has reached apparent breaking point with the pantomime antics on Capitol Hill. The search for long-term alternatives to the dollar is on as never before. Regrettably, there aren't any, or not for the time being in any case. Everyone can only look on in horror as the US commits apparent economic suicide.

Such is the dollar's dominance that, to begin with at least, investors might simply have to take default on the chin. More than 60pc of global foreign exchange reserves are held in US dollars, which also account for more than 80 per cent of global foreign exchange trading.

So important is dollar liquidity in global trade that if, for instance, you wanted to sell Singapore dollars and buy South African rand, your forex dealer would first typically buy US dollars with your Singapore dollars and then use them to buy the South African rand. The dollar is the middle currency in the vast bulk of international transactions.

By the same token, US Treasuries are the very backbone of the global financial system. They are the supposed "risk-free asset" against which everything else is benchmarked, and as such are the collateral of choice in a huge array of financial market transactions. The dollar is also the currency used to price most commodities, from oil to gold.

The dollar's hegemony is all pervasive. This has given the greenback a degree of leverage unmatched by any other reserve currency in history. If China starts to sell dollar assets, it will only weaken the dollar, undermining Chinese exports and reducing the value of its remaining portfolio of dollar assets.

I'd been part of the received wisdom that any act of US default would set off a devastating chain reaction of bankruptcies that would provoke a second global financial crisis. But David Bloom, chief currency strategist at HSBC, has convinced me that dollar hegemony might perversely act in the opposite way, at least initially.

Unlike a generalised credit event, where all instruments default at the same time, the US would initially engage in a series of little, self contained defaults, or "selective defaults", whose individual impact would probably not be that great.

Each bond has a life and coupon of its own. The missed coupon payment might therefore be regarded as not so bad – especially as this is a case of "won't pay", rather than "can't pay".

Markets see such defaults differently, with missed payments expected to be made up eventually once a political resolution is found. It's also very likely that the Federal Reserve would attempt to counter the damage in financial markets with more QE, buying up the Treasuries that investors dumped.

Furthermore, the financial uncertainty created by default would likely drive investors towards past safe havens of choice – in particular, US dollar assets. Alternative safe havens, such as Japan and Switzerland, have been rendered defunct by central bank money printing. Ironically, emerging markets are likely be more damaged by default than the US itself, with further capital flight.

Such is the degree of "exorbitant privilege" enjoyed by the dollar that it might therefore be the first currency in history to see an asset price rally on the back of a default. However, if there were repeated selective defaults, a second, less benign phase would eventually set in. Spooked markets would begin to sell off the dollar.

The consequent stronger euro and pound would have powerfully deflationary consequences for Europe. Internal demand in the US would also collapse as a result of the wrenching fiscal squeeze that would result from federal government attempts to match expenditures with tax revenues.

Dollar hegemony has long been a destabilising force at the centre of the international monetary system; it's a major part of the sharp build-up in global current account imbalances and cross border capital flows that have been at the heart of so many of the problems in the world economy. The unprecedented accumulation of dollar foreign exchange reserves has in turn caused new challenges for the US, making it more difficult to maintain fiscal and financial stability within its own borders.

Policies that may or may not be good for the US are in all probability bad for everyone else. Loose monetary policy in the US since the crisis began has induced unwanted demand and asset bubbles elsewhere in the world.

Serious alternatives to the dollar, such as a global reserve currency, are still a long way off, but the latest shenanigans on Capitol Hill have given the search for them renewed and added momentum. The US is wrecklessly throwing away its future.

Too bad our media passes along the lies about what she said in her 'warning' speeches instead of checking them.

Did she warn of the housing bubble early? No. She tried to downplay the risks and the threats of the housing bubble. Plus she would have made it worse. And promises to do more of the same.

'Peter Schiff goes over in detail the same speeches her supporters put forward and comes to the easy conclusion that the new leader at the Federal Reserve is just as incapable as her predecessors of recognizing a dangerous asset bubble. Worse yet, as a diehard believer in the power of expansive monetary policy, Ms. Yellen would be much less likely to attack an asset bubble even if she were ever to recognize one before it burst.' - http://www.zerohedge.com/news/2013-10-17/janet-yellen-exposed-truth-behind-myth-0

Janet Yellen, 2010: "I didn't see any of that coming until it happened."

“For my own part,” Ms. Yellen said, “I did not see and did not appreciate what the risks were with securitization, the credit ratings agencies, the shadow banking system, the S.I.V.’s — I didn’t see any of that coming until it happened.”

She was wrong then, is wrong now, and will lead us off a cliff much taller and steeper than Obama could do without an accommodating Fed chair, but hey, it's exciting that she is a woman!

It is rare that investors are given a road map. It is rarer still that the vast majority of those who get it are unable to understand the clear signs and directions it contains. When this happens the few who can actually read the map find themselves in an enviable position. Such is currently the case with gold and gold-related investments.

The common wisdom on Wall Street is that gold has seen the moment of its greatness flicker. This confidence has been fueled by three beliefs: A) the Fed will soon begin trimming its monthly purchases of Treasury and Mortgage Backed Securities (commonly called the "taper"), B) the growing strength of the U.S. economy is creating investment opportunities that will cause people to dump defensive assets like gold, and C) the renewed confidence in the U.S. economy will shore up the dollar and severely diminish gold's allure as a safe haven. All three of these assumptions are false. (Our new edition of the Global Investor Newsletter explores how the attraction never dimmed in India).

Recent developments suggest the opposite, that: A) the Fed has no exit strategy and is more likely to expand its QE program than diminish it, B) the U. S. economy is stuck in below-trend growth and possibly headed for another recession C) America's refusal to deal with its fiscal problems will undermine international faith in the dollar....The reality is that Washington has now committed itself to a policy of permanent debt increase and QE infinity that can only possibly end in one way: a currency crisis. While the dollar's status as reserve currency, and America's position as both the world's largest economy and its largest debtor, will create a difficult and unpredictable path towards that destination, the ultimate arrival can't be doubted. The fact that few investors are drawing these conclusions has allowed gold, and precious metal mining stocks, to remain close to multi year lows, even while these recent developments should be signaling otherwise. This creates an opportunity.

Gold moved from $300 to $1,800 not because investors believed the government would hold the line on debt, but because they believed that the U.S. fiscal position would get progressively worse. That is what happened this week....Investors should be concluding that America will never deal with its fiscal problems on its own terms. ... The hard choices that our leaders have just avoided will have to be made someday under far more burdensome circumstances. ... More at link.---------------Or as economic optimist Wesbury put it on radio last week, a choice between jumping out a 2nd floor window now or off the 10th floor rather soon.

As China's currency becomes easier and easier to trade, and as its economy grows, it is becoming an alternative to the greenback. Here's how investors can play the trend.

Throughout the global financial crisis -- even as the problem changed its focus (and name) from the U.S. mortgage-backed securities crisis to the eurozone debt crisis -- the United States could find solace in the strength of the dollar.

It may not have been a currency backed by the largest gold reserves or a well-run fiscal policy, but it needed only to be less bad than its global competitors. And up against a euro that threatens to come apart and a yen backed by a Tokyo government with an even bigger debt problem than Washington has, the dollar looked good enough.

For liquidity, for the depth of its markets and for its ease of transfers and payments, the dollar was relatively strong, because the competition was relatively weak. The dollar was a global currency without real competition. That's been critical to allowing U.S. Treasury prices to rally and yields to fall even after the country lost its AAA credit rating.

The dollar isn't without long-term competitive threats, however. The most obvious of those has long been the Chinese renminbi, or yuan. (China's currency is named the renminbi. The units of the renminbi are the fen, jiao and yuan. It takes 10 fen to make a jiao, and 10 jiao make a yuan. It's as if the U.S. currency was named the dollar, but its units were called the George, the Alexander and the Benjamin.) But that threat, while acknowledged as real, has always seemed very, very distant.

Is the dollar dying?.

Well, I think it's time to at least take one "very" off the timeline. China is moving more quickly than expected to turn its currency into a true global alternative.

How far can it go?

It remains to be seen if the Beijing government can bring itself to give up the kind of control over its currency that would be necessary to turn the renminbi into a real alternative to the dollar. China's economic policies are so grounded in the government's ability to control the exchange rate, and the flow of its currency in and out of the country, that the renminbi may never gain the currency market share that China's economy and reserves could otherwise command. But the global financial crisis -- and the damage suffered by the euro, which had looked like a true alternative to the dollar before the European debt crisis -- has pushed Beijing into action faster than projected even just a year or two ago.

Any real challenge to the dollar from the renminbi isn't going to come tomorrow. But I don't think investors should take the long-term supremacy of the dollar for granted. The likelihood of slippage in the dollar's global role has implications for global stock and bond markets, for U.S. interest rates and for U.S. economic growth rates that you should at least consider in formulating any long-term investment plan.

The latest move -- announced just last week and set to take effect in the third quarter of the year -- is, to me, a bombshell that indicates just how quickly the currency game is changing for the renminbi. (It also suggests a few stocks you might want to consider for your portfolio to take advantage of the long-term currency trend.)

The yuan on the block

Hong Kong Exchanges and Clearing (HKXCY -1.58%, news), trades as 388.HK in Hong Kong but is very thinly traded in New York. The company, which owns and operates the stock and futures exchanges in Hong Kong and related clearinghouses, announced plans to launch the first yuan-denominated futures in the third quarter of 2012. The new product would allow investors to trade against the dollar in contracts priced at $100,000.•Find more from Jubak on his MSN Money home page

Nothing new there. Lots of markets offer futures based on the U.S currency. But this is new and an important change: The contracts will require delivery in dollars by the seller and payment in yuan. In essence, then, the futures allow for the convertibility of dollars and yuan.

The move is another step in China's project of creating a global offshore market for trading renminbi, which really got up to speed with the creation of an offshore market for renminbi in Hong Kong in mid-2010. Until then, the buying and selling of yuan had been largely limited to mainland China under the government's strict currency controls. From July 2010 to January 2011, daily trading in Hong Kong grew from zero to the equivalent of $400 million. Still a drop in the global bucket, but China didn't stop there.

In January 2011, for example, the state-controlled Bank of China allowed customers to trade yuan in the United States. The move was an endorsement of the expansion of yuan trading by Beijing, but it came with the typical truckload of restrictions. Businesses can convert any amount of currency, as long as they are engaged in international trading, but U.S.-based individual customers were limited to $4,000 a day.

In August 2010, McDonald's (MCD -0.96%, news) became the first foreign nonfinancial company to sell yuan-denominated bonds in Hong Kong. Since then, Caterpillar (CAT -6.07%, news) and Volkswagen (VLKAY -1.03%, news) have joined a parade of companies raising capital in yuan-denominated bonds in Hong Kong. In spite of a slump in issuance in the fourth quarter of 2011, the value of new so-called dim sum bonds reached 104 billion yuan -- $16.4 billion. That's almost triple the offerings in 2011.

In December 2011, China and Japan agreed to conduct future bilateral trades directly in yuan. (In 2011, trade between China and Japan amounted to $350 billion.) Before the agreement, Japanese companies, like those from most other countries, had to convert payments into dollars and then into yuan. Each conversion imposed trading costs and exposure to currency fluctuations.

The real big bang, though, is scheduled for 2014, according to the People's Bank. That's when China will roll out a system that would allow countries to settle payments for Chinese goods in yuan instead of dollars. With higher volumes will come lower costs -- in the current system it costs more to do cross-border transfers in yuan than in dollars. That cost differential isn't likely to persist for long, given the volume of its China's global trade. International trade settled in yuan was just $371 billion in 2011.

The new currency swap agreement between the European Central Bank and the People's Bank of China has been in the works for the past few months.

LONDON (CNNMoney)

Europe and China have agreed a currency swap deal to boost trade and investment between the regions.

Under the terms of the deal between the European Central Bank and the People's Bank of China, the swap facility could total as much as 350 billion yuan and €45 billion.

The agreement is one of the largest currency deals between China and a non-Asian trading partner and will last for three years.

Europe and China trade roughly €480 billion in goods and services each year, and the European Union is China's biggest export market.

Related: Yuan now among most traded currencies

China is pushing to internationalize the yuan, and the currency is being used to conduct a growing number of transactions on international markets.

For years Beijing has kept tight control of the yuan, pegging the currency to the U.S. dollar as a way of promoting manufacturing in its export-driven economy, though it has slowly been loosening its hold recently.

The swap deal will allow more trade and investment between the regions to be conducted in euros and yuan, without having to convert into another currency such as the U.S. dollar first, said Kathleen Brooks, a research director at FOREX.com.

"It's a way of promoting European and Chinese trade, but not doing it with the U.S. dollar," said Brooks. "It's a bit like cutting out the middleman, all of a sudden there's potentially no U.S. dollar risk."

Related: U.S. debt loses some appeal in Hong Kong

In June, China struck a similar agreement with the Bank of England worth up to 200 billion yuan.

The deal with the ECB comes as political gridlock in the U.S. weakens the U.S. dollar against many other global currencies.

A spokesperson for the ECB said the deal had been in the works for the last few months.

The yuan, also called the renminbi, currently trades directly with the U.S. dollar, the Australian dollar and the Japanese yen.

In September, the Bank for International Settlements announced the Chinese yuan was the ninth most traded currency in the world.

The yuan was involved in 2.2% of foreign exchange trading worldwide in April, the period examined by the report, more than double its share in April 2010.

The dollar was involved in 87% of all trades, the euro was part of 33% of trades, and the Japanese yen was involved in 23%.

More than one point in this strike me as unsound, but tossing it out there nonetheless:

How the Dollar Could Eventually CollapseBy William Tucker on 10.23.13 @ 6:11AMTwo events last week were a reminder, as if any were still needed.

The great issue in Washington that divides Republican and Democrats is whether we can go on running deficits and piling up the national debt without some day reaching a point of reckoning.

Democrats adhere to the Keynesian/Paul Krugman school, which says that “deficits don’t matter,” “we owe it to ourselves,” and that printing money is the best and fairest way to stimulate the economy. (Actually, this viewpoint is adopted by whichever party happens to be in power. The Republicans argued the same thing when they controlled the government during the Bush and Reagan years.)

The Republicans and other green-eyeshade types argue that out-of-control deficit spending can’t go on. It’s like a household budget. Any country that runs up a negative account balance will eventually hit bankruptcy. If it tries to inflate its way out of debt, people will start to doubt the value of money and the currency will collapse. Savings will be wiped out and the nation will become penurious.

So far the neo-Keynesians seem to be winning. Federal Reserve Chairman Ben Bernanke has been pursuing his policy of “quantitative easing” (which just means printing more dollars) for five years without producing any negative consequences. Inflation has remained low and the dollar has actually strengthened against some currencies, particularly the Euro as European countries sink into their own financial crises. True, we have now run up a national debt of approximately 100 percent of GDP, which is exactly where Greece was when things started to fall apart. But as everyone observes, no one really thinks the United States is as vulnerable as a little country 11 million people that lives on olives and tourism.

Then there is the example of Japan. The Japanese have had a national debt of 200 percent of GDP for nearly a decade. True, their economy has been in the doldrums for almost two decades and no one talks about the Japanese overtaking the American economy anymore. But once again the Japanese experience seems to confirm that “deficits don’t matter.” You can run up a huge national debt without suffering any immediate consequences.

Two things happened in London last week, however, that indicate there might be a flaw to this argument after all. There won’t be any consequences next week or the week after, but in the long run they may point to the place where America’s house of cards — or paper dollars — could eventually collapse. As Kenneth Rogoff, co-author of This Time It’s Different, says, “Any country that sits with a historically large debt for too long is taking a chance that some out-of-the-box event will shake up markets and raise interest rates to the point where funding becomes very painful. Wars and unexpected catastrophes do happen and the historical transformations that follow can occur.”So here’s what happened in London:• The British, faced with declining natural gas production in the North Sea and reluctant to embrace fracking, are facing power blackouts this winter. So they have decided to go with nuclear. They have quickly discovered, however, that America no longer has a nuclear industry and France, the one European country that has embraced nuclear, is bogged down in bureaucracy and political opposition. So they have turned to the country where nuclear construction and technology are making rapid progress — China. Last week Chancellor of the Exchequer George Osborne announced he would allow Chinese nuclear companies to invest in British reactor projects and eventually take ownership of them. • Almost simultaneously, the Exchequer announced that Britain will allow Chinese banks to set up branches for wholesale banking in London. The decision is part of an effort to steal a mark on Frankfurt and Paris to become the hub of trading in the Yuan, the Chinese currency, in Europe. Having Chinese banks operating in London will allow direct trading between the Yuan and the British pound, instead of going by way of the dollar as things are done now.The significance of these two events is hard to convey without sounding alarmed, but I will give it a try. First the nuclear part. At the end of the day, as the saying goes, the world is going to have little choice except to go nuclear. China and India are already proving that, even if you’re not particularly concerned about global warming, running an industrial nation on coal produces insufferable air pollution. China just passed the United States on total electricity generated and China and India combined will probably have to produce ten times more if they are to lift their populations out of poverty — which their people desperately want. We may be able to divert ourselves into natural gas for awhile, even though it is a huge waste. (Gas would be much better utilized as methanol to run our cars.) But in the end, the world is going to move to nuclear power — there is no other way.

All this will create enormous economic opportunities. Countries that can build nuclear infrastructure are going to grow rich. The Koreans have landed a $20 billion contract to build four reactors in the United Arab Emirates and that is just the beginning. The Hinckley Point Reactor in Britain — the one the Chinese are investing in — is estimated at $22 billion. There are 70 reactors under construction right now, mostly in Russia and Asia. The builders include Russia, China, Korea and Japan,— which is still selling its technology abroad even though public opinion is opposing it at home. France was in the lead for awhile but has fallen victim to the general sclerosis of European institutions. At the Olkiluoto project in Finland, the Finnish environmental bureaucracy has taken months to sign off on approvals that were supposed to be done in days and the project is now five years behind schedule with completion still out of sight. Before she was forced out of her job, Anne Lauvergeon, former CEO of France’s Areva, was complaining that the Chinese were able to build French-designed reactors faster and cheaper than the French could themselves.

So the task or producing the world’s industrial infrastructure is rapidly shifting from West to East. So will the cutting edge of innovation. Bill Gates sat in the lobby of the Nuclear Regulatory Commission in Beltsville, Maryland, for a year (figuratively) before finally realizing the task of getting the bureaucrats to look at his Traveling Wave reactor was hopeless. So he took his invention to China. The design, which burns continuously for 50 years, consuming its own waste in the process, is now being developed by the Chinese National Nuclear Corporation.

That’s one thing. Now what about this banking business? Well, the Chinese here are striking at our Achilles’ heel — the role of the dollar as the world’s reserve currency. Let’s go back to Ben Bernanke’s “qualitative easing” and the argument that the national debt doesn’t matter because “we owe it to ourselves.” The fact is we don’t owe it to ourselves anymore. Fully one-third of our debt is owned by foreigners. China and Japan are the largest stakeholders, each owning 7 percent. If we just owed this money to American investors, we could just stiff them the way the government stiffed bondholders at GM and Chrysler — or the way savers are currently being stiffed by the Fed’s zero interest rates. There is nothing anyone could do except move their money abroad. (This is apparently already happening, since the U.S. is experiencing a negative investment capital outflow.)

But the real danger lies in the dollar’s role as the world’s reserve currency. This is the legacy of our hugely productive economy during and after World War II when we played the role of world leadership. “At the Bretton Woods Conference of 1944, the major western powers turned over responsibility for maintaining a stable world currency to the United States,” says Lewis Lehrman, the long-time advocate of the gold standard. “Unfortunately, it’s a responsibility that we haven’t fulfilled.”

Until 1971, the dollar was pegged to gold at $35 an ounce. But with inflation raging and gold flying out of Fort Knox, President Nixon renounced the exchange rate and said that the dollar would float against other currencies. “Since 1971 we’ve been living in an era of inconvertible paper currency,” says Lehrman. Gold now sells at $1300 an ounce, a 2000 percent depreciation since 1971.

So what “quantitative easing” really means is that we are dumping out domestic profligacy on the rest of the world. We go on running up debt and printing dollars and the rest of the world is forced to take them because, based on its former stability, the dollar still serves as the international means of exchange in 60 percent of world trade. There are now more $100 bills circulating abroad than at home. It’s the kind of situation that will go on until someone successfully challenges the dollar’s role as the world currency.

That challenge will almost certainly come from China.

As holders of $1.1 trillion in American debt, the Chinese are the principal victims of our inflationary policies. So far, however, there’s not much they can do about it. In 2009, as the American economy was collapsing, Chinese Prime Minister Wen Jiabao warned “We have lent a huge mount of money to the US. Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little worried.” The Chinese can’t rock the boat too hard, however, without endangering their own assets. As the great swindler Billie Sol Estes once said, “When you owe someone $1000, you’re in debt. When you owe them $1 million, you’ve got yourself a partner.”

What the Chinese have been doing, however, is quietly building a financial infrastructure that would allow them and the rest of the world to free themselves from dependency on the dollar. They have suggested substituting promissory notes from the International Monetary Fund in world trade and struck deals with Russia and the OPEC nations to trade outside the dollar. They have established direct exchange of the yuan with Hong Kong, Taiwan and Singapore. Last spring Australia agreed to make its currencies directly convertible with the yuan and has since shifted 5 percent of its reserve holdings into yuan instead of dollars. The Chinese are negotiating a similar arrangement with New Zealand. And now they will be moving into London and the European market as well.

All this may seem very distant but it represents an historical shift that could come about very quickly. “We hear arguments that China has a long was to go before they could become a major international reserve currency but let’s not kid ourselves. The process is already underway and a lot further down the road than most people think,” says Stuart Oakley, head of foreign exchange trading at Nomura, a global investment bank in Singapore. Michael Pento, president of Pento Portfolio Strategies, who writes frequently for Huffington Post, adds: “The No. 1 security issue we have as a nation is the preservation of the U.S. dollar as the world’s reserve currency. It’s a thousand times more important than a nuclear bomb being tested by North Korea. Yet we are doing everything to abuse that status.”

At any one time, up to 35 percent of the dollar’s value comes from its role in international trade. This is what differentiates us from Japan, which may have twice our national debt but does not have the same exposure in international markets. If the dollar were to be toppled from its role as the world’s reserve currency, it would set off a run on the dollar in which every American could lose up to a third of his net worth.

At that point, people might start paying attention to what the Tea Party is saying.

====================

Scott Grannis responds: OMG, the sky is falling!

All this essay says is that if the demand for dollars were to collapse, and if the Fed were to not do anything in response, and if the federal government were to continue to borrow extreme amounts of money, then the value of the dollar would likely collapse. That's a lot of very big "ifs."

Even the author acknowledges that the Chinese can't really do anything about their massive dollar exposure. They're stuck. See my post "Pity the Chinese."

It's true that we can't go running massive deficits forever, but right now we're not. The deficit has fallen from 10.5% of GDP to about 4.5% in just four relatively short years. The federal government hasn't increased its spending at all for the past four years, even as tax revenues have grown at double digit rates. The Fed has done an awful lot of QE, but sooner or later that is going to come to an end, even when Janet Yellen takes over the reins from Ben.

There's also a strong mercantilist strain in the essay, which asserts that those who know how to build nuclear reactors are going to get rich, presumably at the expense of those that don't. No one country could build enough nuclear reactors to cause any significant shift in the relative prosperity of other countries. The ones getting the reactors are going to benefit as well: the cost of a reactor is proportionate to it's benefit, is it not?

Yes, the sky could fall, but lots of bad things would have to happen along the way.

New York TimesBINYAMIN APPELBAUMPublished: October 26, 2013 • WASHINGTON — Inflation is widely reviled as a kind of tax on modern life, but as Federal Reserve policy makers prepare to meet this week, there is growing concern inside and outside the Fed that inflation is not rising fast enough.

Some economists say more inflation is just what the American economy needs to escape from a half-decade of sluggish growth and high unemployment. The Fed has worked for decades to suppress inflation, but economists, including Janet Yellen, President Obama’s nominee to lead the Fed starting next year, have long argued that a little inflation is particularly valuable when the economy is weak. Rising prices help companies increase profits; rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow money and spend it more quickly.

The school board in Anchorage, Alaska, for example, is counting on inflation to keep a lid on teachers’ wages. Retailers including Costco and Walmart are hoping for higher inflation to increase profits. The federal government expects inflation to ease the burden of its debts. Yet by one measure, inflation rose at an annual pace of 1.2 percent in August, just above the lowest pace on record.

“Weighed against the political, social and economic risks of continued slow growth after a once-in-a-century financial crisis, a sustained burst of moderate inflation is not something to worry about,” Kenneth S. Rogoff, a Harvard economist, wrote recently. “It should be embraced.”

The Fed, in a break from its historic focus on suppressing inflation, has tried since the financial crisis to keep prices rising about 2 percent a year. Some Fed officials cite the slower pace of inflation as a reason, alongside reducing unemployment, to continue the central bank’s stimulus campaign.

Critics, including Professor Rogoff, say the Fed is being much too meek. He says that inflation should be pushed as high as 6 percent a year for a few years, a rate not seen since the early 1980s. And he compared the Fed’s caution to not swinging hard enough at a golf ball in a sand trap. “You need to hit it more firmly to get it up onto the grass,” he said. “As long as you’re in the sand trap, tapping it around is not enough.”

All this talk has prompted dismay among economists who see little benefit in inflation, and who warn that the Fed could lose control of prices as the economy recovers. As inflation accelerates, economists agree that any benefits can be quickly outstripped by the disruptive consequences of people rushing to spend money as soon as possible. Rising inflation also punishes people living on fixed incomes, and it discourages lending and long-term investments, imposing an enduring restraint on economic growth even if the inflation subsides.

“The spectacle of American central bankers trying to press the inflation rate higher in the aftermath of the 2008 crisis is virtually without precedent,” Alan Greenspan, the former Fed chairman, wrote in a new book, “The Map and the Territory.” He said the effort could end in double-digit inflation.

The current generation of policy makers came of age in the 1970s, when a higher tolerance for inflation did not deliver the promised benefits. Instead, Western economies fell into “stagflation” — rising prices, little growth.

Lately, however, the 1970s have seemed a less relevant cautionary tale than the fate of Japan, where prices have been in general decline since the late 1990s. Kariya, a popular instant dinner of curry in a pouch that cost 120 yen in 2000, can now be found for 68 yen, according to the blog Yen for Living.

This enduring deflation, which policy makers are now trying to end, kept the economy in retreat as people hesitated to make purchases, because prices were falling, or to borrow money, because the cost of repayment was rising.

“Low inflation is not good for the economy because very low inflation increases the risks of deflation, which can cause an economy to stagnate,” the Fed’s chairman, Ben S. Bernanke, a student of Japan’s deflation, said in July. “The evidence is that falling and low inflation can be very bad for an economy.”

There is evidence that low inflation is hurting the American economy.

“I’ve always said that a little inflation is good,” Richard A. Galanti, Costco’s chief financial officer, said in December 2008. He explained that the retailer is generally able to expand its profit margins and its sales when prices are rising. This month, Mr. Galanti told analysts that sluggish inflation was one reason the company had reported its slowest revenue growth since the recession.

Executives at Walmart, Rent-A-Center and Spartan Stores, a Michigan grocery chain, have similarly bemoaned the lack of inflation in recent months.

Page 2 of 2)

Many households also have reason to miss higher inflation. Historically, higher prices have led to higher wages, allowing borrowers to repay fixed debts like mortgage loans more easily. Over the five years before 2008, inflation raised prices 10 percent. Over the last five years, prices rose 8 percent. At the current pace, prices would rise 6 percent over the next five years.

“Let me just remind everyone that inflation falling below our target of 2 percent is costly,” Charles L. Evans, the president of the Federal Reserve Bank of Chicago, said in a speech in Madison, Wis., this month. “If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy.”

Inflation also helps workers find jobs, according. to an influential 1996 paper by the economist George Akerlof and two co-authors. Rising prices allows companies to increase profit margins quietly, by not raising wages, which in turn makes it profitable for companies to hire additional workers. Lower rates of inflation have the opposite effect, making it harder to find work.

Companies could cut wages, of course. But there is ample evidence that even during economic downturns, companies are reluctant to do so. Federal data show a large spike since the recession in the share of workers reporting no change in wages, but a much smaller increase in workers reporting wage cuts, according to an analysis by the Federal Reserve Bank of San Francisco. There is, in practice, an invisible wall preventing pay cuts. The standard explanation is that employers fear that workers will be angry and therefore less productive.

“I want to be really careful about advocating for lower wages because I typically advocate for the other side of that equation,” said Jared Bernstein, a fellow at the left-leaning Center on Budget and Policy Priorities and a former economic adviser to Vice President Joseph R. Biden Jr. “But I think higher inflation would help.”

The Anchorage school board, facing pressure to cut costs because of a budget shortfall, began contract negotiations with its 3,500 teachers this year by proposing to freeze rather than cut wages. The final deal, completed last month, gives the teachers raises of 1 percent in each of the next three years.

Teachers, while not thrilled, described the deal as better than a pay cut. But it is likely, in effect, to cut the teachers’ pay. Economists expect prices to rise about 2 percent a year over the next three years, so even as the teachers take home more dollars, those dollars would have less value. Instead of a 1 percent annual increase, the teachers would fall behind by 1 percent a year.

“We feel like this contract still allows us to attract and retain quality educators,” said Ed Graff, the Anchorage school district superintendent.

In June, Caterpillar, the industrial equipment maker, persuaded several hundred workers at a Wisconsin factory to accept a six-year wage freeze. The company described the workers as overpaid, but it did not seek direct cuts.

The slow pace of inflation, however, minimizes the benefits. Seeking further savings, Caterpillar has since laid off almost half of the workers.

The gradual erosion of the U.S. dollar's status as the world's reserve currency has been greatly hastened of late. This is due not only to the perpetual gridlock in D.C., but also our government's inability to articulate a strategy to deal with the $126 trillion of unfunded liabilities.

Our addictions to debt and cheap money have finally caused our major international creditors to call for an end to dollar hegemony and to push for a "de-Americanized" world.

China, the largest U.S. creditor with $1.28 trillion in Treasury bonds, recently put out a commentary through the state-run Xinhua news agency stating that, "Such alarming days when the destinies of others are in the hands of a hypocritical nation have to be terminated."

Washington's messiness and the dollar

Congress finally reached a deal to end the 16-day shutdown, but it wasn't pretty. CNBC's Rick Santelli makes the case that the dollar's weakness is more about the Fed and a mediocre economy.

In addition, Japan (our second largest creditor holding $1.14 trillion of U.S. debt) put out a statement through its Finance Minister last week saying, "The U.S. must avoid a situation where it cannot pay, and its triple-A ranking plunges all of a sudden."

(Read more: Fed in 'monetary roach motel,' won't taper: Schiff)

It is both embarrassing and hypocritical to be lectured by Japan about an intractable debt situation. However, the sad truth is we have become completely reliant on these two nations for the stability of our bond market and currency.

We arrived at this condition because our central bank has compelled the nation to rely on asset bubbles for growth and prevented the deleveraging of the economy by forcing down interest rates far below a market-based level.

For example, instead of allowing debt levels to shrink, the Fed's virtually free money has now caused consumer credit to surge past the $3 trillion mark by the second quarter 2013; that is up 22 percent in the past three years. And of course, the Federal government massively stepped up its borrowing beginning in 2008, piling on over $6.8 trillion in additional publicly traded debt since the start of the Great Recession.

(Read more: It's back with a vengeance: Private debt)

While most are now celebrating the end of government gridlock (however ephemeral it may be), the truth is few understand the consequences of our addictions.

The real problems of government largess, money printing, artificial interest rates, asset bubbles and debt have not been addressed at all. Rather, Washington has merely agreed to perpetually extend its lines of credit and to have the central bank purchase most of that new debt.

Instead of placating the fears of our foreign creditors we have cemented into their minds that the U.S. dollar and bond market cannot be safe repositories of their savings. The eventual and inevitable loss of that confidence will ensure nothing less than surging prices and a complete collapse of our economy.

The fear of an economic meltdown was the genesis of a constitutionally-based third-party political movement.

The Tea Party was formed to prevent runaway inflation and an economic depression resulting from a crumbling currency and devalued debt. It appears by the absolute and universal vilification of its members by both Republicans and Democrats that U.S. citizens are not yet ready to undergo the pain associated with the removal of our pernicious addictions.

(Read more: Tea party leader takes protest to new level)

Since there appears to be no political solution in site it would benefit investors to take steps now to protect their portfolios from the de-crowning of the U.S. dollar as the world's reserve currency.

—Michael Pento is president of Pento Portfolio Strategies and author of The Coming Bond Market Collapse: How to Survive the Demise of the U.S. Debt Market.

The great issue in Washington that divides Republican and Democrats is whether we can go on running deficits and piling up the national debt without some day reaching a point of reckoning.

Democrats adhere to the Keynesian/Paul Krugman school, which says that “deficits don’t matter,” “we owe it to ourselves,” and that printing money is the best and fairest way to stimulate the economy. (Actually, this viewpoint is adopted by whichever party happens to be in power. The Republicans argued the same thing when they controlled the government during the Bush and Reagan years.)

The Republicans and other green-eyeshade types argue that out-of-control deficit spending can’t go on. It’s like a household budget. Any country that runs up a negative account balance will eventually hit bankruptcy. If it tries to inflate its way out of debt, people will start to doubt the value of money and the currency will collapse. Savings will be wiped out and the nation will become penurious.

So far the neo-Keynesians seem to be winning. Federal Reserve Chairman Ben Bernanke has been pursuing his policy of “quantitative easing” (which just means printing more dollars) for five years without producing any negative consequences. Inflation has remained low and the dollar has actually strengthened against some currencies, particularly the Euro as European countries sink into their own financial crises. True, we have now run up a national debt of approximately 100 percent of GDP, which is exactly where Greece was when things started to fall apart. But as everyone observes, no one really thinks the United States is as vulnerable as a little country 11 million people that lives on olives and tourism.

Then there is the example of Japan. The Japanese have had a national debt of 200 percent of GDP for nearly a decade. True, their economy has been in the doldrums for almost two decades and no one talks about the Japanese overtaking the American economy anymore. But once again the Japanese experience seems to confirm that “deficits don’t matter.” You can run up a huge national debt without suffering any immediate consequences.

Two things happened in London last week, however, that indicate there might be a flaw to this argument after all. There won’t be any consequences next week or the week after, but in the long run they may point to the place where America’s house of cards — or paper dollars — could eventually collapse. As Kenneth Rogoff, co-author of This Time It’s Different, says, “Any country that sits with a historically large debt for too long is taking a chance that some out-of-the-box event will shake up markets and raise interest rates to the point where funding becomes very painful. Wars and unexpected catastrophes do happen and the historical transformations that follow can occur.”

So here’s what happened in London: The British, faced with declining natural gas production in the North Sea and reluctant to embrace fracking, are facing power blackouts this winter. So they have decided to go with nuclear. They have quickly discovered, however, that America no longer has a nuclear industry and France, the one European country that has embraced nuclear, is bogged down in bureaucracy and political opposition. So they have turned to the country where nuclear construction and technology are making rapid progress — China. Last week Chancellor of the Exchequer George Osborne announced he would allow Chinese nuclear companies to invest in British reactor projects and eventually take ownership of them. Almost simultaneously, the Exchequer announced that Britain will allow Chinese banks to set up branches for wholesale banking in London. The decision is part of an effort to steal a mark on Frankfurt and Paris to become the hub of trading in the Yuan, the Chinese currency, in Europe. Having Chinese banks operating in London will allow direct trading between the Yuan and the British pound, instead of going by way of the dollar as things are done now.

The significance of these two events is hard to convey without sounding alarmed, but I will give it a try. First the nuclear part. At the end of the day, as the saying goes, the world is going to have little choice except to go nuclear. China and India are already proving that, even if you’re not particularly concerned about global warming, running an industrial nation on coal produces insufferable air pollution. China just passed the United States on total electricity generated and China and India combined will probably have to produce ten times more if they are to lift their populations out of poverty — which their people desperately want. We may be able to divert ourselves into natural gas for awhile, even though it is a huge waste. (Gas would be much better utilized as methanol to run our cars.) But in the end, the world is going to move to nuclear power — there is no other way.

All this will create enormous economic opportunities. Countries that can build nuclear infrastructure are going to grow rich. The Koreans have landed a $20 billion contract to build four reactors in the United Arab Emirates and that is just the beginning. The Hinckley Point Reactor in Britain — the one the Chinese are investing in — is estimated at $22 billion. There are 70 reactors under construction right now, mostly in Russia and Asia. The builders include Russia, China, Korea and Japan,— which is still selling its technology abroad even though public opinion is opposing it at home. France was in the lead for awhile but has fallen victim to the general sclerosis of European institutions. At the Olkiluoto project in Finland, the Finnish environmental bureaucracy has taken months to sign off on approvals that were supposed to be done in days and the project is now five years behind schedule with completion still out of sight. Before she was forced out of her job, Anne Lauvergeon, former CEO of France’s Areva, was complaining that the Chinese were able to build French-designed reactors faster and cheaper than the French could themselves.

So the task or producing the world’s industrial infrastructure is rapidly shifting from West to East. So will the cutting edge of innovation. Bill Gates sat in the lobby of the Nuclear Regulatory Commission in Beltsville, Maryland, for a year (figuratively) before finally realizing the task of getting the bureaucrats to look at his Traveling Wave reactor was hopeless. So he took his invention to China. The design, which burns continuously for 50 years, consuming its own waste in the process, is now being developed by the Chinese National Nuclear Corporation.

That’s one thing. Now what about this banking business? Well, the Chinese here are striking at our Achilles’ heel — the role of the dollar as the world’s reserve currency. Let’s go back to Ben Bernanke’s “qualitative easing” and the argument that the national debt doesn’t matter because “we owe it to ourselves.” The fact is we don’t owe it to ourselves anymore. Fully one-third of our debt is owned by foreigners. China and Japan are the largest stakeholders, each owning 7 percent. If we just owed this money to American investors, we could just stiff them the way the government stiffed bondholders at GM and Chrysler — or the way savers are currently being stiffed by the Fed’s zero interest rates. There is nothing anyone could do except move their money abroad. (This is apparently already happening, since the U.S. is experiencing a negative investment capital outflow.)

But the real danger lies in the dollar’s role as the world’s reserve currency. This is the legacy of our hugely productive economy during and after World War II when we played the role of world leadership. “At the Bretton Woods Conference of 1944, the major western powers turned over responsibility for maintaining a stable world currency to the United States,” says Lewis Lehrman, the long-time advocate of the gold standard. “Unfortunately, it’s a responsibility that we haven’t fulfilled.”

Until 1971, the dollar was pegged to gold at $35 an ounce. But with inflation raging and gold flying out of Fort Knox, President Nixon renounced the exchange rate and said that the dollar would float against other currencies. “Since 1971 we’ve been living in an era of inconvertible paper currency,” says Lehrman. Gold now sells at $1300 an ounce, a 2000 percent depreciation since 1971.

So what “quantitative easing” really means is that we are dumping out domestic profligacy on the rest of the world. We go on running up debt and printing dollars and the rest of the world is forced to take them because, based on its former stability, the dollar still serves as the international means of exchange in 60 percent of world trade. There are now more $100 bills circulating abroad than at home. It’s the kind of situation that will go on until someone successfully challenges the dollar’s role as the world currency.

That challenge will almost certainly come from China.

As holders of $1.1 trillion in American debt, the Chinese are the principal victims of our inflationary policies. So far, however, there’s not much they can do about it. In 2009, as the American economy was collapsing, Chinese Prime Minister Wen Jiabao warned “We have lent a huge mount of money to the US. Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little worried.” The Chinese can’t rock the boat too hard, however, without endangering their own assets. As the great swindler Billie Sol Estes once said, “When you owe someone $1000, you’re in debt. When you owe them $1 million, you’ve got yourself a partner.”

What the Chinese have been doing, however, is quietly building a financial infrastructure that would allow them and the rest of the world to free themselves from dependency on the dollar. They have suggested substituting promissory notes from the International Monetary Fund in world trade and struck deals with Russia and the OPEC nations to trade outside the dollar. They have established direct exchange of the yuan with Hong Kong, Taiwan and Singapore. Last spring Australia agreed to make its currencies directly convertible with the yuan and has since shifted 5 percent of its reserve holdings into yuan instead of dollars. The Chinese are negotiating a similar arrangement with New Zealand. And now they will be moving into London and the European market as well.

All this may seem very distant but it represents an historical shift that could come about very quickly. “We hear arguments that China has a long was to go before they could become a major international reserve currency but let’s not kid ourselves. The process is already underway and a lot further down the road than most people think,” says Stuart Oakley, head of foreign exchange trading at Nomura, a global investment bank in Singapore. Michael Pento, president of Pento Portfolio Strategies, who writes frequently for Huffington Post, adds: “The No. 1 security issue we have as a nation is the preservation of the U.S. dollar as the world’s reserve currency. It’s a thousand times more important than a nuclear bomb being tested by North Korea. Yet we are doing everything to abuse that status.”

At any one time, up to 35 percent of the dollar’s value comes from its role in international trade. This is what differentiates us from Japan, which may have twice our national debt but does not have the same exposure in international markets. If the dollar were to be toppled from its role as the world’s reserve currency, it would set off a run on the dollar in which every American could lose up to a third of his net worth.

At that point, people might start paying attention to what the Tea Party is saying.

The Consumer Price Index (CPI) increased 0.2% in September, exactly as the consensus expected. The CPI is up 1.2% versus a year ago.“Cash” inflation (which excludes the government’s estimate of what homeowners would charge themselves for rent) increased 0.2% in September and is up 0.9% in the past year.

The gain in the CPI in September was led by energy and rent. Energy rose 0.8%, while rent (including homeowners’ equivalent rent) rose 0.2%. Food prices were unchanged. The “core” CPI, which excludes food and energy, was up 0.1% in September, slightly below the consensus expected rise of 0.2%. Core prices are up 1.7% versus a year ago.

Real average hourly earnings – the cash earnings of all employees, adjusted for inflation – were flat in September, and are up 0.9% in the past year. Real weekly earnings are also up 0.9% in the past year.

Implications: The Federal Reserve is comfortable with today’s inflation report. Consumer prices rose a consensus expected 0.2% overall and only 0.1% excluding food and energy. Energy and rent led the gains. Compared to a year ago, overall consumer prices are up 1.2% while core prices are up 1.7%. Neither of these figures sets off alarm bells. Instead, they suggest the Fed’s preferred measure of inflation, the PCE deflator (which usually runs a ¼ point below the overall CPI) will remain below the Fed’s target of 2%. We don’t expect this to last. Inflation bottomed in April when it was up only 1.1% from the prior year, and we expect it will be noticeably higher a year from now. Recent figures underscore a slight acceleration in inflation, with the overall CPI up at a 1.7% annual rate in the past three months. However, for the Fed, the key measure of inflation is its own forecast of future inflation. So, even if inflation moves higher, as long as the Fed projects the rise to be temporary it will not react to that inflation alone by raising short-term interest rates. The Fed is more focused on the labor market and, we believe, is willing to let inflation exceed its long-term target of 2% for a prolonged period of time in order to get the unemployment rate down. In other news this morning, the ADP Employment index, which measures private-sector payrolls, was up 130,000 in October. As a result, our models for the official report (out Friday November now forecast payroll gains of 90,000 nonfarm and 135,000 private. Not bad at all considering the partial government shutdown during the survey period. We expect payroll gains to rebound sharply in November.

Anyone out there want to point out which article or amendment in the constitution authorizes the federal government to 'buy up' $1.25 trillion in 'mortgage backed securities' as a way of injecting purely inflationary money into the system in an attempt to 'stimulate' business and consumption in the economy? Good God, what have we become?------------------------------

I can only say: I'm sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed's first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I've come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.

Five years ago this month, on Black Friday, the Fed launched an unprecedented shopping spree. By that point in the financial crisis, Congress had already passed legislation, the Troubled Asset Relief Program, to halt the U.S. banking system's free fall. Beyond Wall Street, though, the economic pain was still soaring. In the last three months of 2008 alone, almost two million Americans would lose their jobs.

The Fed said it wanted to help—through a new program of massive bond purchases. There were secondary goals, but Chairman Ben Bernanke made clear that the Fed's central motivation was to "affect credit conditions for households and businesses": to drive down the cost of credit so that more Americans hurting from the tanking economy could use it to weather the downturn. For this reason, he originally called the initiative "credit easing."

My part of the story began a few months later. Having been at the Fed for seven years, until early 2008, I was working on Wall Street in spring 2009 when I got an unexpected phone call. Would I come back to work on the Fed's trading floor? The job: managing what was at the heart of QE's bond-buying spree—a wild attempt to buy $1.25 trillion in mortgage bonds in 12 months. Incredibly, the Fed was calling to ask if I wanted to quarterback the largest economic stimulus in U.S. history.

This was a dream job, but I hesitated. And it wasn't just nervousness about taking on such responsibility. I had left the Fed out of frustration, having witnessed the institution deferring more and more to Wall Street. Independence is at the heart of any central bank's credibility, and I had come to believe that the Fed's independence was eroding. Senior Fed officials, though, were publicly acknowledging mistakes and several of those officials emphasized to me how committed they were to a major Wall Street revamp. I could also see that they desperately needed reinforcements. I took a leap of faith.

In its almost 100-year history, the Fed had never bought one mortgage bond. Now my program was buying so many each day through active, unscripted trading that we constantly risked driving bond prices too high and crashing global confidence in key financial markets. We were working feverishly to preserve the impression that the Fed knew what it was doing.

It wasn't long before my old doubts resurfaced. Despite the Fed's rhetoric, my program wasn't helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn't getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.

From the trenches, several other Fed managers also began voicing the concern that QE wasn't working as planned. Our warnings fell on deaf ears. In the past, Fed leaders—even if they ultimately erred—would have worried obsessively about the costs versus the benefits of any major initiative. Now the only obsession seemed to be with the newest survey of financial-market expectations or the latest in-person feedback from Wall Street's leading bankers and hedge-fund managers. Sorry, U.S. taxpayer.

Trading for the first round of QE ended on March 31, 2010. The final results confirmed that, while there had been only trivial relief for Main Street, the U.S. central bank's bond purchases had been an absolute coup for Wall Street. The banks hadn't just benefited from the lower cost of making loans. They'd also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed's QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.

You'd think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2. Germany's finance minister, Wolfgang Schäuble, immediately called the decision "clueless."

That was when I realized the Fed had lost any remaining ability to think independently from Wall Street. Demoralized, I returned to the private sector.

Where are we today? The Fed keeps buying roughly $85 billion in bonds a month, chronically delaying so much as a minor QE taper. Over five years, its bond purchases have come to more than $4 trillion. Amazingly, in a supposedly free-market nation, QE has become the largest financial-markets intervention by any government in world history.

And the impact? Even by the Fed's sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrast, experts outside the Fed, such as Mohammed El Erian at the Pimco investment firm, suggest that the Fed may have created and spent over $4 trillion for a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output). Both of those estimates indicate that QE isn't really working.

Unless you're Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.

As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again "bubble-like." Meanwhile, the country remains overly dependent on Wall Street to drive economic growth.

Even when acknowledging QE's shortcomings, Chairman Bernanke argues that some action by the Fed is better than none (a position that his likely successor, Fed Vice Chairwoman Janet Yellen, also embraces). The implication is that the Fed is dutifully compensating for the rest of Washington's dysfunction. But the Fed is at the center of that dysfunction. Case in point: It has allowed QE to become Wall Street's new "too big to fail" policy.

Mr. Huszar, a senior fellow at Rutgers Business School, is a former Morgan Stanley managing director. In 2009-10, he managed the Federal Reserve's $1.25 trillion agency mortgage-backed security purchase program.

For all the hoopla over budget improvement, deficit % of GDP is still 30% worse than 2008. Under this likely-to-be-temporary spending sequester in the last fiscal year before Obamcare, and taxing at the highest tax rates in recent memory, we are still spending 25% above and beyond what we take in! What could possibly go wrong?

Tapering…please bring it on. We wanted it yesterday, or last month, or even years ago. We never thought QE helped the economy and certainly don’t think keeping it around is a good idea. It’s created uncertainty at an unprecedented level. But, we aren’t holding our breath waiting for the Fed to change course. Despite better data on the economy, the Fed will take its sweet time, possibly waiting until March before slowing the pace of “quantitative easing,” the monthly purchase of $85 billion in long-term securities. With Vice-Chair Janet Yellen on tap for the top spot at the Fed and more potential budget fights looming in January/February, it’s hard to imagine the Fed rushing to do something that might spook the markets.

However, in addition to Yellen’s promotion, another change is afoot at the central bank that dovetails (pun intended) well with her ascent. A recent study by Fed staffers says monetary policy would be more effective at boosting economic growth if policymakers signaled their intentions by using the unemployment rate as the trigger for rate hikes.

At present, the Fed says as long as its own forecast of inflation stays below 2.5% it won’t even consider rate hikes until the unemployment rate hits 6.5%. But the new paper suggests the Fed would get more economic bang for the buck from this forward commitment if it cut the jobless threshold to 5.5% instead. The theory is that by committing to a longer time period for a zero federal funds rate, the Fed could hold long-term interest rates down, which would stimulate the economy.

In other words, the new study has given the Fed a way to move forward with tapering and, in its own view, loosen monetary policy at the same time.

The Fed is, in effect, admitting that quantitative easing was never the reason long-term interest rates fell in the first place. It wasn’t the amount or make-up of bonds the Fed was buying that mattered; instead, quantitative easing was just a tool the Fed could use to signal how long that short-term rates would stay at zero. The more securities the Fed would buy and the longer it committed to buying them, the longer it would take to end those purchases, which meant the longer it would be before the Fed finally got around to raising short-term rates.

And with long-term interest rates largely a function of expected short-term rates over the same time horizon, prolonging expectations of zero short term rates meant – violà – long-term rates fell and stayed down as well. Think about it. If you could guarantee that overnight interest rates would be zero for the next three years, the yield on the 3-year Treasury would be very close to zero as well.

The problem with all this new chatter about reducing the unemployment threshold is that it doesn’t adequately contemplate how policymakers a few years down the road will react, when the economy hits this lower threshold. The new Fed paper assumes a future Fed will move up short-term rates aggressively enough to prevent inflation from becoming a persistent problem. Inflation might stay above the 2% long-run goal for a little while, the theory goes, but the Fed would then wrestle it back down.

We’re more inclined to think that after tasting inflation above 2% for a couple of years the Fed will, due to either political pressure or an ideology it doesn’t want to fully reveal, look for excuses to accept a new long-run inflation target above 2%, and then above 2.5%, and then, maybe, at or above 3%.

We’re not saying the US is doomed to repeat the same exact mistakes of the 1970s with double-digit inflation. But a hallmark of that period was a never-ending stream of excuses for not stabilizing prices. The Fed has just found a new excuse and investors should plan accordingly. The days of 1% inflation are nearing an end. Look out above.

"This sounds like a gutsy/crazy move. Selling yuan bonds is equivalent to shorting the yuan, which has been appreciating almost continuously against every currency on the planet, though much less against the CAD than against the US dollar. However, the CAD is close to an all-time high against the US dollar, and seems very unlikely to appreciate further. CAD could decline against US as US declines against CNY. Not an obvious strategy to pursue in my book. Better to buy those bonds than sell them"

The Producer Price Index (PPI) declined 0.2% in October, matching consensus expectations. Producer prices are up 0.3% versus a year ago.The decline in the overall PPI was due to energy, which dropped 1.5%. Food prices increased 0.8%. The “core” PPI, which excludes food and energy, rose 0.2% in October.

Consumer goods prices declined 0.2% in October while capital equipment prices rose 0.1%. In the past year, consumer goods prices are up 0.1% while capital equipment prices are up 1.0%.

Core intermediate goods prices declined 0.1% in October but are up 0.8% versus a year ago. Core crude prices declined 0.5% in October, and are down 5.1% versus a year ago.

Implications: The wait for higher inflation continues. Overall producer prices declined 0.2% in October, led by a 1.5% drop in energy costs, which more than offset a 0.8% gain in food prices and a 0.2% increase in “core” prices, which exclude food and energy. Producer prices are up only 0.3% in the past year. “Core” producer prices are up 1.4% from a year ago, faster than the overall gain but not fast by the standards of the past several decades. As a result, some analysts still say the Federal Reserve has room to continue quantitative easing at the current pace of $85 billion per month. We think this would be a mistake. The problems that ail the economy are fiscal and regulatory in nature; continuing to add more excess reserves to the banking system is not going to boost economic growth, but, for the time being, it won’t lift inflation either. In other news this morning, initial claims for unemployment insurance fell 21,000 last week to 323,000. Continuing claims increased 66,000 to 2.87 million. However, the gain in continuing claims follows a drop of 64,000 the prior week, so the most recent gain just returned claims to around the level from two weeks before. Plugging these figures into our payroll models, we’re now forecasting November payroll gains of 153,000, both nonfarm and private. On the manufacturing front, the Philly Fed index, a measure of factory sentiment in that region, slowed to a still positive +6.5 in November from +19.8 in October. The index has remained positive for six consecutive months, signaling continued expansion in the manufacturing sector.

Global regulators need more policy tools to counter the risk of devastating bank runs and should have powers over a wide array of market participants, U.S. Federal Reserve Governor Dan Tarullo said on Friday.

"There is a need to supplement prudential bank regulation with a third set of policy options in the form of regulatory tools that can be applied on a market-wide basis," Tarullo said at a conference on shadow banking.

I shared the piece of my previous post with Scott Grannis, who commented as follows:

"Obviously this guy doesn't know much about international finance and trade theory. What's going on in China represents no threat to the U.S. or to the dollar. The announcement referenced here is not new news, and it only means that China is going to step up its purchases of U.S. goods and services. And by the way, our federal deficit has been plunging, so if China buys less of our debt it's hardly a problem. The problem would be if they wanted to buy more. I'm inspired to write this up more formally as a post. More to come, probably after Thanksgiving."